10-Q 1 sho-110318x10q.htm 10-Q Document

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549 
_______________________________________________
FORM 10-Q
_______________________________________________ 
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
FOR THE QUARTERLY PERIOD ENDED NOVEMBER 3, 2018
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-35641 
_______________________________________________
SEARS HOMETOWN AND OUTLET STORES, INC.
(Exact Name of Registrant as Specified in Its Charter)
_______________________________________________
DELAWARE
 
80-0808358
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)
 
 
5500 TRILLIUM BOULEVARD, SUITE 501 HOFFMAN ESTATES, ILLINOIS
 
60192
(Address of Principal Executive Offices)
 
(Zip Code)
Registrant’s Telephone Number, Including Area Code: (847) 286-7000 
_______________________________________________
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
 
¨ 
  
Accelerated filer
 
¨

 
 
 
 
Non-accelerated filer (Do not check if a smaller reporting company)
 
                     ¨ 
  
Smaller reporting company
 
ý

 
 
 
 
 
 
 
 
 
 
 
Emerging growth company
 
¨


If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.




Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
As of December 6, 2018 the registrant had 22,702,132 shares of common stock, par value $0.01 per share, outstanding.
 



SEARS HOMETOWN AND OUTLET STORES, INC.
INDEX TO QUARTERLY REPORT ON FORM 10-Q
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017
 
 
 
 
 
Page
 
 
PART I—FINANCIAL INFORMATION
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
PART II—OTHER INFORMATION
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.




SEARS HOMETOWN AND OUTLET STORES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
 
 
 
13 Weeks Ended
 
39 Weeks Ended
Thousands, except per share amounts
 
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
NET SALES
 
$
339,115

 
$
385,959

 
$
1,151,428

 
$
1,324,177

COSTS AND EXPENSES
 
 
 
 
 
 
 
 
Cost of sales and occupancy
 
254,284

 
299,271

 
887,167

 
1,051,386

Selling and administrative
 
85,376

 
93,101

 
269,860

 
319,190

Depreciation and amortization
 
2,399

 
3,002

 
8,786

 
9,910

Gain on sale of assets
 
(1,358
)
 

 
(1,358
)
 

Total costs and expenses
 
340,701

 
395,374

 
1,164,455

 
1,380,486

Operating loss
 
(1,586
)
 
(9,415
)
 
(13,027
)
 
(56,309
)
Interest expense
 
(3,601
)
 
(2,149
)
 
(10,657
)
 
(5,614
)
Other income
 
93

 
194

 
349

 
744

Loss before income taxes
 
(5,094
)
 
(11,370
)
 
(23,335
)
 
(61,179
)
Income tax benefit (expense)
 
594

 
437

 
140

 
(634
)
NET LOSS
 
$
(4,500
)
 
$
(10,933
)
 
$
(23,195
)
 
$
(61,813
)
 
 
 
 
 
 
 
 
 
NET LOSS PER COMMON SHARE ATTRIBUTABLE TO STOCKHOLDERS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic:
 
$
(0.20
)
 
$
(0.48
)
 
$
(1.02
)
 
$
(2.72
)
Diluted:
 
$
(0.20
)
 
$
(0.48
)
 
$
(1.02
)
 
$
(2.72
)
 
 
 
 
 
 
 
 
 
Basic weighted average common shares outstanding
 
22,702

 
22,702

 
22,702

 
22,702

Diluted weighted average common shares outstanding
 
22,702

 
22,702

 
22,702

 
22,702

See Notes to Condensed Consolidated Financial Statements.


1


SEARS HOMETOWN AND OUTLET STORES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

Thousands
 
November 3, 2018
 
October 28, 2017
 
February 3, 2018
ASSETS
 
 
 
 
 
 
CURRENT ASSETS
 
 
 
 
 
 
Cash and cash equivalents
 
$
43,150

 
$
13,994

 
$
10,402

Accounts and franchisee receivables, net
 
9,663

 
13,151

 
14,672

Merchandise inventories
 
297,606

 
354,825

 
336,294

Prepaid expenses and other current assets
 
7,749

 
9,777

 
7,131

Total current assets
 
358,168

 
391,747

 
368,499

PROPERTY AND EQUIPMENT, net
 
31,149

 
39,284

 
36,049

OTHER ASSETS, net
 
3,574

 
9,767

 
8,140

TOTAL ASSETS
 
$
392,891

 
$
440,798

 
$
412,688

LIABILITIES
 
 
 
 
 
 
CURRENT LIABILITIES
 
 
 
 
 
 
Short-term borrowings
 
$
107,000

 
$
119,200

 
$
137,900

Term Loan, net
 
38,847

 

 

Payable to Sears Holdings Corporation
 
21,706

 
26,114

 
28,082

Accounts payable
 
15,553

 
23,613

 
15,741

Other current liabilities
 
57,076

 
60,499

 
53,142

Total current liabilities
 
240,182

 
229,426

 
234,865

OTHER LONG-TERM LIABILITIES
 
2,484

 
2,589

 
2,284

TOTAL LIABILITIES
 
242,666

 
232,015

 
237,149

COMMITMENTS AND CONTINGENCIES (Note 10)
 

 

 

STOCKHOLDERS' EQUITY
 
 
 
 
 
 
TOTAL STOCKHOLDERS' EQUITY
 
150,225

 
208,783

 
175,539

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
392,891

 
$
440,798

 
$
412,688

See Notes to Condensed Consolidated Financial Statements.


2


SEARS HOMETOWN AND OUTLET STORES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
 
39 Weeks Ended
Thousands
 
November 3, 2018
 
October 28, 2017
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
 
Net loss
 
$
(23,195
)
 
$
(61,813
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
 
 
 
 
Depreciation and amortization
 
8,786

 
9,910

Gain on sale of assets
 
(1,358
)
 

Amortization of debt issuance costs
 
710

 

Provision for losses on franchisee receivables
 
2,911

 
5,820

Share-based compensation
 

 
(103
)
Change in operating assets and liabilities:
 
 
 
 
Accounts and franchisee receivables
 
2,098

 
(1,124
)
Merchandise inventories
 
38,688

 
18,990

Payable to Sears Holdings Corporation
 
(6,376
)
 
(54,610
)
Accounts payable
 
(188
)
 
5,760

Store closing accrual
 
(3,526
)
 
(2,827
)
Other operating assets and liabilities, net
 
9,271

 
(5,559
)
Net cash provided by (used in) operating activities
 
27,821

 
(85,556
)
CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
 
Proceeds from sale of assets
 
2,837

 

Purchases of property and equipment
 
(5,105
)
 
(7,037
)
Net cash used in investing activities
 
(2,268
)
 
(7,037
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
 
Net short-term (payments) borrowings on senior ABL facility
 
(30,900
)
 
92,400

Net (payments) borrowings of capital lease obligations
 
(42
)
 
83

Proceeds from term loan agreement
 
40,000

 

Debt issuance costs
 
(1,863
)
 

Net cash provided by financing activities
 
7,195

 
92,483

NET CHANGE IN CASH AND CASH EQUIVALENTS
 
32,748

 
(110
)
CASH AND CASH EQUIVALENTS—Beginning of period
 
10,402

 
14,104

CASH AND CASH EQUIVALENTS—End of period
 
$
43,150

 
$
13,994

 
 
 
 
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
 
 
 
 
Cash paid for interest
 
$
8,156

 
$
5,781

Cash paid for income taxes
 
$
1,135

 
$
757

See Notes to Condensed Consolidated Financial Statements.


3


SEARS HOMETOWN AND OUTLET STORES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited)
 
Thousands
Number of Shares of Common Stock
 
Common Stock/Par Value
 
Capital in Excess of Par Value
 
Accumulated Deficit
 
Total Stockholders' Equity
Balance at January 28, 2017
22,716

 
$
227

 
$
555,481

 
$
(285,009
)
 
$
270,699

Net loss

 

 

 
(61,813
)
 
(61,813
)
Share-based compensation
(14
)
 

 
(103
)
 

 
(103
)
Balance at October 28, 2017
22,702

 
$
227

 
$
555,378

 
$
(346,822
)
 
$
208,783

 
 
 
 
 
 
 
 
 
 
Balance at February 3, 2018
22,702

 
$
227

 
$
555,378

 
$
(380,066
)
 
$
175,539

Net loss

 

 

 
(23,195
)
 
(23,195
)
Cumulative effect adjustment from adoption of new accounting standards

 

 

 
(2,119
)
 
(2,119
)
Balance at November 3, 2018
22,702

 
$
227

 
$
555,378

 
$
(405,380
)
 
$
150,225

See Notes to Condensed Consolidated Financial Statements.



4

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)



NOTE 1—BACKGROUND AND BASIS OF PRESENTATION

Background

Sears Hometown and Outlet Stores, Inc. is a national retailer primarily focused on selling home appliances, lawn and garden equipment, and tools. As of November 3, 2018 the Company or its dealers and franchisees operated a total of 761 stores across 49 states, Puerto Rico, and Bermuda. In these notes and elsewhere in this Quarterly Report on Form 10-Q the terms “we,” “us,” “our,” “SHO,” and the “Company” refer to Sears Hometown and Outlet Stores, Inc. and its subsidiaries.

Our common stock trades on the NASDAQ Stock Market under the trading symbol “SHOS.”
 
The Separation

The Company separated from Sears Holdings Corporation (“Sears Holdings”) in October 2012 (the “Separation”). To our knowledge Sears Holdings does not own any shares of our common stock. The Company has specified rights to use the "Sears" name under a license agreement from Sears Holdings.

Basis of Presentation

These unaudited Condensed Consolidated Financial Statements include the accounts of Sears Hometown and Outlet Stores, Inc. and its subsidiaries, all of which are wholly owned. These unaudited Condensed Consolidated Financial Statements do not include all of the information and footnotes required in annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the 13 and 39 weeks ended November 3, 2018 are not necessarily indicative of the results that may be expected for the full fiscal year. These financial statements and related notes should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended February 3, 2018 (the "2017 10-K").

We operate through two segments--our Sears Hometown segment ("Hometown") and our Sears Outlet segment ("Outlet").

Our third fiscal-quarter end is the Saturday closest to October 31. For 2018 and 2017, our third fiscal quarters ended as follows:
Fiscal Year
Third Quarter Ended
Weeks        
2018
November 3, 2018
13
2017
October 28, 2017
13

Our fiscal year end is the Saturday closest to January 31. Our 2018 fiscal year will end February 2, 2019.

Unless otherwise stated, references to specific years and quarters in these notes are to fiscal years and fiscal quarters, respectively.

On October 15, 2018 and thereafter Sears Holdings and many of its subsidiaries filed voluntary petitions in the United States Bankruptcy Court for the Southern District of New York seeking relief under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code"). The Company, which is not a subsidiary of Sears Holdings, is not included in the bankruptcy petitions filed by Sears Holdings and its subsidiaries, and neither the Company nor its subsidiaries have filed a bankruptcy petition. The Company has significant business relationships with Sears Holdings and its affiliates that are Chapter 11 debtors (together, the "Sears Holdings Debtors") through various agreements among the Company, Sears Holdings and, in some circumstances, subsidiaries of Sears Holdings (as amended, the “SHO-Sears Holdings Agreements”). Generally, debtors in Chapter 11 cases, like the Sears Holdings Debtors, have the right, subject to bankruptcy court approval, to reject contracts that are deemed to be "executory contracts" within the meaning of the Bankruptcy Code. Generally, the effect of rejection of an executory contract is that the debtor is relieved of its future performance obligations and any damages resulting from the rejection would be treated as prepetition unsecured claims. Some or all of the SHO-Sears Holdings Agreements may constitute executory contracts that could be subject to rejection in the Chapter 11 cases of the Sears Holdings Debtors (the "Sears Holdings Bankruptcy Proceedings"). None of the Sears Holdings Debtors has disclosed whether it will seek to reject the SHO-Sears Holdings Agreements. Sears Holdings has announced that it is seeking in the Sears Holdings Bankruptcy Proceedings to liquidate its assets through the sale of several hundred stores, together with other assets, on a going concern basis, and that it is seeking bids with the goal of completing a going concern sale in January

5

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


2019. The Official Committee of Unsecured Creditors appointed in the Sears Holdings Bankruptcy Proceedings (the "Sears Holdings UCC") objected to the entry of an order to approve bidding procedures for a going concern sale on the basis that the Sears Holdings UCC believes that the sale as a going concern, in contrast to a complete asset liquidation, might not maximize creditor recoveries. Sears Holdings has obtained Bankruptcy Court approval for the bid procedures, which contemplate going-concern and liquidation-basis bids. The Company believes that if the Sears Holdings Debtors were to liquidate on a basis other than as a going concern, there is an increased likelihood that the Sears Holdings Debtors would seek to reject some or all of the SHO-Sears Holdings Agreements.

If Sears Holdings were to cease performing under any of the SHO-Sears Holdings Agreements, as a result of the rejection in the Sears Holdings Bankruptcy Proceedings or otherwise, the Company could lose access to services performed by Sears Holdings (including merchandise supply services) and rights granted to the Company under the SHO-Sears Holdings Agreements that are critical to the operation of the Company’s businesses. In such a situation, there could be a significant risk (1) to the Company's ability to conduct its businesses in the ordinary course (especially the Hometown businesses, given their dependence on purchasing KENMORE® and CRAFTSMAN® branded merchandise and other merchandise from Sears Holdings under the SHO-Sears Holdings Agreements), and (2) that the Company's results of operations, financial condition, liquidity, and cash flows could be materially and adversely affected. A termination of the SHO-Sears Holdings Agreements could require the Company to, among other things, find different service and product providers. Even if the Company were able to find replacement products and services, these products and services might not be of the same type or quality as those which are currently provided by Sears Holdings, and the Company's access to Kenmore and Craftsman branded merchandise could become significantly more expensive or cease altogether. If the Company were forced to enter into new agreements for replacement products and services, the new agreements could include terms and conditions that were less favorable to the Company than the terms and conditions of the SHO-Sears Holdings Agreements, including products and services that are lower in quality and value and more expensive.

The Company has developed plans and alternatives that are intended to mitigate many of the adverse consequences to the Company if Sears Holdings were to cease performing critical services (including merchandise supply services) for the Company. These plans and alternatives include but are not limited to (1) taking actions to reduce or eliminate dependence on Sears Holdings’s IT systems by completing the Company’s IT transformation project, (2) contracting with third-party logistics providers to replace services currently provided by Sears Holdings, and (3) using direct purchasing agreements that are in place with a significant portion of the Company’s merchandise vendors to provide to the Company critical categories of merchandise currently supplied by Sears Holdings.

The Company is party to an Amended and Restated Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent and collateral agent, which provides (subject to availability under a borrowing base) for aggregate maximum borrowings of $170 million (the “Senior ABL Facility”). The Company is also a party to a Term Loan Agreement with Gordon Brothers Finance Company, as agent, lead arranger, and sole bookrunner, and Gordon Brothers Finance Company, LLC, as lender (the “Term Loan”). See Note 8 - Financing Arrangements. The Senior ABL Facility will mature on the earliest of the following dates: (1) February 29, 2020; (2) six months prior to the expiration of specified "Separation Agreements" (which term is defined in the Senior ABL Facility to include specified SHO-Sears Holdings Agreements) unless the Separation Agreements are extended to a date later than February 29, 2020 or are terminated on a basis reasonably satisfactory to the Senior ABL lenders; and (3) acceleration of the maturity date following an event of default in accordance with the Senior ABL Facility. The Term Loan will mature on the earliest of (1) the maturity date specified in the Senior ABL Facility, (2) February 16, 2023, and (3) acceleration of the maturity date following an event of default in accordance with the Term Loan Agreement. The Senior ABL Facility and the Term Loan Agreement each provides that the rejection by Sears Holdings of "the Separation Agreements" is an event of default thereunder, which could result in all amounts outstanding to become immediately due and payable. The Company has proposed to Sears Holdings that the duration of the Separation Agreements that expire on February 1, 2020 be extended, which proposal Sears Holdings has not yet accepted. The Company believes that the Senior ABL Facility lenders, with respect to the Senior ABL Facility, and the Term Loan lenders, with respect to the Term Loan, could assert that the Senior ABL Facility and the Term Loan would mature on August 1, 2019. The Company will seek to refinance the Senior ABL Facility and Term Loan prior to August 1, 2019, which efforts the Company believes will be augmented by the Company’s improved adjusted EBITDA performance over the last 18 months as well as the value of the Company’s inventory and other assets that would be available as collateral to lenders. The Company has had initial discussions with the administrative agent for the Senior ABL Facility about its extension or refinancing, and the Company expects to continue such discussions and to engage in discussions with the Term Loan lender, with a goal of completing a replacement credit facility or facilities for the Senior ABL Facility and the Term Loan during the first quarter of fiscal 2019.


6

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The Company is subject to Accounting Standards Update 2014-15, Presentation of Financial Statements - Going Concern, codified as Accounting Standards Codification (ASC) 205-40 (the "Accounting Evaluation Requirements"), which requires management to evaluate an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or, in certain cases, available to be issued). ASC 205-40 states that conditions or events that raise "substantial doubt" about an entity’s ability to continue as a going concern typically relate to the entity’s ability to meet its obligations as they become due, generally within one year after the date that the financial statements are issued. The evaluation of whether substantial doubt is raised does not take into account the potential mitigating effect of management’s plans that have not been fully implemented. If conditions or events indicate that substantial doubt is raised, management is required to evaluate whether its plans that are intended to mitigate those conditions and events will alleviate substantial doubt. ASC 205-40 specifies that management may consider its plans only when it is "probable" that those plans will be effectively implemented and that the plans will mitigate the relevant conditions and events within one year after the financial statements are issued. This probability determination is based on the specific facts and circumstances of the entity and involves significant judgment.

While we believe that we will be able to refinance the Senior ABL Facility and the Term Loan, and that the refinancing would satisfy our liquidity needs through the end of our 2019 fiscal year, such refinancing has not occurred and cannot be considered "probable" (as defined by the Accounting Evaluation Requirements) as of the date of inclusion of these financial statements in the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended November 3, 2018. The Company will continue to seek to refinance the Senior ABL Facility and the Term Loan. Because we cannot at this time conclude that any proposed refinancing is "probable" of occurring under the Accounting Evaluation Requirements, and due to the uncertainty of the effect on our businesses (especially with respect to our Hometown businesses) and financial performance that could occur if Sears Holdings were to cease performing critical services for the Company, "substantial doubt" (as defined by the Accounting Evaluation Requirements) is deemed to exist about our ability to continue as a going concern.

Reclassifications

Certain amounts have been reclassified in order to conform to the current-period presentation.

Revenue Recognition

Revenues from contracts with customers include sales of merchandise, commissions on merchandise sales made through www.sears.com, Company websites, services and extended-service plans, financing programs, and delivery and handling revenues related to merchandise sold. Revenue is measured based on the amount of fixed consideration that we expect to receive, reduced by estimates for variable consideration such as returns. Revenue also excludes any amounts collected from customers and remitted or payable to governmental authorities. In arrangements where we have multiple performance obligations, the transaction price is allocated to each performance obligation using the relative stand-alone selling price.

We recognize revenues from retail operations upon the transfer of control of goods to the customer. We satisfy our performance obligations at the point of sale for retail store transactions and upon delivery for online transactions. We defer revenue for retail store and online transactions including commissions on extended-service plans, where we have received consideration but have not transferred control of the goods to the customer at the end of the period. The performance obligation is generally satisfied in the following reporting period. The balance of deferred revenue was $16.6 million and $16.4 million at November 3, 2018 and February 3, 2018, respectively. The change in deferred revenue represents additional revenue deferred during the first three quarters of 2018. We recognize revenues from commissions on services, and delivery and handling revenues related to merchandise sold, at the point of sale as we are not the primary obligor with respect to such services and have no future obligations for future performance.

The Company accepts Sears Holdings gift cards as tender for purchases and is reimbursed weekly by Sears Holdings for gift cards tendered.


7

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Cost of Sales and Occupancy

Cost of sales and occupancy is comprised principally of merchandise costs, warehousing and distribution (including receiving and store delivery) costs, retail store occupancy costs, home services and installation costs, warranty cost, royalties payable to Sears Holdings related to our sale of products branded with one of the KENMORE®, CRAFTSMAN®, and DIEHARD® marks (the "KCD Marks"), customer shipping and handling costs, vendor allowances, markdowns, and physical inventory losses. The KCD Marks are owned by, or licensed to, subsidiaries of Sears Holdings.

Reserve for Sales Returns and Allowances

Revenues from merchandise sales and services are reported net of estimated returns and allowances and exclude sales taxes. The typical return period is 30 days. The refund liability for returns is calculated as a percentage of sales based on historical return percentages. Estimated returns are recorded as a reduction of revenues. The reserve for returns and allowances was $3.9 million and $1.1 million at November 3, 2018 and February 3, 2018, respectively. Refer to the Recently Adopted Accounting Pronouncements discussion below.

Variable Interest Entities and Consolidation

The Financial Accounting Standards Board ("FASB") has issued guidance on variable interest entities and consolidation for determining whether an entity is a variable interest entity ("VIE") as well as the methods permitted for determining the primary beneficiary of a VIE. In addition, this guidance requires ongoing reassessments as to whether a reporting company is the primary beneficiary of a VIE and disclosures regarding the reporting company’s involvement with a VIE.

On an ongoing basis the Company evaluates its business relationships, such as those with its independent dealers, independent franchisees, and suppliers, to identify potential VIE's. Generally, these businesses either qualify for a scope exception under the consolidation guidance or, where a variable interest exists, the Company does not possess the power to direct the activities that most significantly impact the economic performance of these businesses. The Company has not consolidated any of such entities in the periods presented.

Fair Value of Financial Instruments

We determine the fair value of financial instruments in accordance with standards pertaining to fair value measurements. Such standards define fair value and establish a framework for measuring fair value under GAAP. Under fair value measurement accounting standards, fair value is considered to be the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. We report the fair value of financial assets and liabilities based on the fair value hierarchy prescribed by accounting standards for fair value measurements, which prioritizes the inputs to valuation techniques used to measure fair value into three levels, as follows:

Level 1 inputs—unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. An active market for the asset or liability is one in which transactions for the asset or liability occurs with sufficient frequency and volume to provide ongoing pricing information.

Level 2 inputs—inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly, for the asset or liability. Level 2 inputs include, but are not limited to, quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted market prices that are observable for the asset or liability, such as interest-rate curves and yield curves observable at commonly quoted intervals, volatilities, credit risks, and default rates.

Level 3 inputs—unobservable inputs for the asset or liability.

Cash and cash equivalents, merchandise payables, accrued expenses (Level 1), accounts and franchisee notes receivable, and short-term debt (Level 2) are reflected in the Condensed Consolidated Balance Sheets at cost, which approximates fair value due to the short-term nature of these instruments. For short-term borrowings and our Term Loan, the variable interest rates are a significant input in our fair value assessments and are consistent with the interest rates in the market. The carrying value of long-term notes receivable approximates fair value.


8

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


We may be required, on a nonrecurring basis, to adjust the carrying value of the Company's long-lived assets. When necessary, these valuations are determined by the Company using Level 3 inputs. These assets are subject to fair value adjustments in certain circumstances as when there is evidence that impairment may exist. The Company was not required to measure any other significant non-financial asset or liability at fair value as of November 3, 2018.
    
Recently Issued Accounting Pronouncements

Recently issued accounting pronouncements that are not yet effective and that we have not discussed in the 2017 10-K or below are either inapplicable to us or, if applicable, we do not expect that they will have a material impact on our consolidated results of operations, consolidated financial condition, or consolidated cash flows.

ASU 2016-02 "Leases (Topic 842)"
In February 2016, the FASB issued Accounting Standards Update ("ASU") 2016-02, "Leases (Topic 842)". This ASU is a comprehensive new accounting standard with respect to leases that amends various aspects of existing guidance for leases and requires additional disclosures about leasing arrangements. It requires companies to record assets and liabilities on the balance sheet for leases that were formerly designated as operating leases as well as leases designated as financing leases. The provisions of the ASU predominately change the recognition of leases for lessees, but the provisions do not substantially change the accounting for lessors. This ASU will supersede the provisions of Topic 840 Leases. In July 2018, the FASB issued ASU 2018-11, "Leases (Topic 842): Targeted Improvements", which provides an optional transition method to apply ASU 2016-02 in the period of adoption and recognize a cumulative-effect opening transition adjustment to retained earnings, without applying the standard to comparative periods. This ASU also provides lessors with a practical expedient to account for lease and associated non-lease components as a single component when certain criteria are met.

The provisions of this ASU are effective for fiscal years beginning after December 15, 2018, and interim periods within those periods. Early adoption is allowed; however, we will adopt the standard in the first quarter of fiscal 2019. We have upgraded our existing third-party leasing software and identified business processes, systems and controls to support adoption of the new standard. We are in the process of evaluating the impact that the new standard will have on the condensed consolidated financial statements. While we are unable to quantify the impact at this time, we expect the adoption of the new standard to result in a material increase in the assets and liabilities in the condensed consolidated balance sheets. At this time, we do not expect the adoption of ASU 2016-02 to have a material impact on our condensed consolidated statements of operations as the majority of our leases will remain operating in nature. As such, expense recognition will be similar to previously required straight-line expense treatment.

Recently Adopted Accounting Pronouncements

ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)"
In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)", which supersedes the revenue recognition requirements in Accounting Standards Codification (ASC) 605, Revenue Recognition. Several additional ASUs have subsequently been issued amending and clarifying the standard. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides a five-step process to achieve that core principle and to determine when and how revenue is recognized. The updates may be applied retrospectively for each period presented or as a cumulative-effect adjustment at the date of adoption.

We adopted this standard on February 4, 2018, using the modified retrospective approach. The impact of the adoption of ASU 2014-09 on our condensed consolidated financial statements is as follows:

Our revenue is primarily generated from the sales of merchandise to customers through the retail, e-commerce or wholesale channels. Our performance obligations underlying such sales, and the timing of revenue recognition related thereto, remain substantially unchanged following the adoption of this ASU.
The adoption of ASU No. 2014-09 requires that we recognize our sales return allowance on a gross basis rather than as a net liability. As such, we now recognize (i) a return asset for the right to recover the goods returned by the customer, measured at the former carrying amount of the goods, less any expected recovery costs (recorded as an increase to prepaid expenses and other current assets), (ii) a return liability for the amount of expected returns (recorded as an increase to other current liabilities) and (iii) deferred revenue for commissions earned on extended protection agreements (recorded as an increase to other current liabilities).


9

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


We have made accounting policy elections to (1) exclude from the measurement of transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by us from a customer (sales tax, value added tax, etc.) and (2) account for shipping and handling activities performed after a customer obtains control of the good as activities to fulfill the promise to transfer the good.

We applied ASU No. 2014-09 only to contracts that were not completed prior to fiscal 2018. The cumulative effect of initially applying ASU No. 2014-09 was a $2.1 million increase to the opening balance of accumulated deficit as of February 4, 2018. The comparative prior period information continues to be reported under the accounting standards in effect during those periods.

The effect of the adoption of ASU No. 2014-09 on our consolidated balance sheet as of November 3, 2018 was as follows:
Thousands
 
As Reported
 
ASU 2014-09 Effect
 
Excluding ASU 2014-09 Effect
Prepaid expenses and other current assets
 
$
7,749

 
$
1,226

 
$
6,523

Other current liabilities
 
57,076

 
3,345

 
53,731

Accumulated deficit
 
(405,380
)
 
(2,119
)
 
(403,261
)

NOTE 2—NET SALES

During the 13 and 39 weeks ended November 3, 2018, approximately 98% of our revenues were generated in the United States.

Net sales of merchandise and services for the 13 and 39 weeks ended November 3, 2018 were as follows:
Thousands
13 Weeks Ended November 3, 2018
 
39 Weeks Ended November 3, 2018
Merchandise
$
312,441

 
$
1,064,057

Services
20,155

 
66,934

Other
6,519

 
20,437

Net sales
$
339,115

 
$
1,151,428

NOTE 3—ACCOUNTS AND FRANCHISEE RECEIVABLES AND OTHER ASSETS
Accounts and franchisee receivables and other assets consist of the following: 
Thousands
 
November 3, 2018
 
October 28, 2017
 
February 3, 2018
Short-term franchisee receivables
 
$
591

 
$
1,584

 
$
1,205

Miscellaneous receivables
 
9,663

 
12,593

 
14,314

Long-term franchisee receivables
 
1,683

 
10,829

 
7,962

Other assets
 
3,574

 
5,057

 
5,106

Allowance for losses on short-term franchisee receivables (1)
 
(591
)
 
(1,027
)
 
(847
)
Allowance for losses on long-term franchisee receivables (1)
 
(1,683
)
 
(6,118
)
 
(4,928
)
Net accounts and franchisee receivables and other assets
 
$
13,237

 
$
22,918

 
$
22,812


(1) The Company recognizes an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs and existing economic conditions and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling and administrative expense. Most of our franchisee promissory notes authorize us to deduct debt service from our commissions otherwise due and payable to the franchisees, and we routinely make those deductions to the extent of available commissions payable. As of November 3, 2018, all franchisee receivables have been fully reserved for losses.

10

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 4—ALLOWANCE FOR LOSSES ON FRANCHISEE RECEIVABLES
The allowance for losses on franchisee receivables consists of the following as of:  
 
39 Weeks Ended
Thousands
November 3, 2018
 
October 28, 2017
Allowance for losses on franchisee receivables, beginning of period
$
5,775

 
$
8,242

Provisions during the period
2,911

 
5,820

Write off of franchisee receivables
(6,412
)
 
(6,917
)
Allowance for losses on franchisee receivables, end of period
$
2,274

 
$
7,145


On November 2, 2018, the Company and a franchisee entered into a transaction consisting of agreements that terminated all of the franchisee's franchise agreements and sublease arrangements for 21 franchised locations. The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases. The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $2.7 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes. During the 39 weeks ended November 3, 2018, the Company recognized a loss of $2.7 million on the transaction.

On June 7, 2017, the Company and a franchisee entered into a transaction consisting of agreements that terminated all of the franchisee's franchise agreements and sublease arrangements for 14 franchised locations (except with respect to one location as to which the Company would either assume the lease or enter into a lease directly with the landlord). The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases (in one instance pursuant to an Occupancy Agreement). The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $5.5 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes and received a new promissory note from the franchisee in the amount of $1.5 million, which is payable in installments through December 11, 2022. During the 39 weeks ended October 28, 2017, the Company recognized a loss of $5.5 million on the transaction.
NOTE 5—OTHER CURRENT AND LONG-TERM LIABILITIES
Other current and long-term liabilities consist of the following:
Thousands
November 3, 2018
 
October 28, 2017
 
February 3, 2018
Customer deposits
$
16,675

 
$
17,761

 
$
16,655

Sales and other taxes
7,148

 
8,782

 
9,221

Accrued expenses
25,154

 
23,191

 
17,755

Payroll and related items
9,454

 
8,522

 
7,140

Store closing and severance costs
1,129

 
4,832

 
4,655

Other current and long-term liabilities
$
59,560

 
$
63,088

 
$
55,426


NOTE 6—INCOME TAXES

SHO and Sears Holdings entered into a Tax Sharing Agreement that governs the rights and obligations of the parties with respect to pre-Separation and post-Separation tax matters. Under the Tax Sharing Agreement, Sears Holdings generally is responsible for any federal, state, or foreign income tax liability relating to tax periods ending on or before the Separation. For all periods after the Separation, the Company generally is responsible for any federal, state, or foreign tax liability. Current income taxes payable for any federal, state, or foreign income taxes are reported in the period incurred.

We account for uncertainties in income taxes according to accounting standards for uncertain tax positions. The Company is present in a large number of taxable jurisdictions and, at any point in time, can have tax audits underway at various stages of completion in one or more of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite our belief that the underlying tax positions are

11

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closings of statutes of limitation. Such adjustments are reflected in the tax provision as appropriate. For the 13 and 39 weeks ended November 3, 2018 and October 28, 2017, no unrecognized tax benefits have been identified and reflected in the Condensed Consolidated Financial Statements.

We classify interest expense and penalties related to unrecognized tax benefits and interest income on tax overpayments as components of income tax expense. As no unrecognized tax benefits have been identified and reflected in the Condensed Consolidated Financial Statements, no interest or penalties related to unrecognized tax benefits are reflected in the Condensed Consolidated Balance Sheets or Statements of Operations.

Management assesses the available positive and negative evidence to estimate whether sufficient future taxable income will be generated to realize the benefit of the existing deferred tax assets. A significant piece of objective negative evidence evaluated was the cumulative loss for the three years ended February 3, 2018. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future income. On the basis of this analysis, management has established a full valuation allowance to offset the net deferred tax assets that are not expected to be realized. Management will continue to evaluate objective and subjective evidence for changes in circumstances that cause a change in judgment about the realizability of the deferred tax assets.

We file federal, state, and city income tax returns in the United States and foreign tax returns in Puerto Rico. The U.S. Internal Revenue Service ("IRS") has commenced an audit of the Company's federal income tax return for the fiscal year ended January 30, 2016. SHO was also a part of Sears Holdings's combined state returns for the fiscal years ended February 2, 2013 and February 1, 2014. Currently, the Company is under audit in one state for the years ended February 2, 2013 and February 1, 2014 as part of the Sears Holdings’ combined return audits and two separate return states for the years ended February 1, 2014 through January 28, 2017.

The Tax Cuts and Jobs Act was enacted on December 22, 2017. The Act reduced the U.S. federal corporate income tax rate from 35% to 21%, eliminated corporate alternative minimum tax ("AMT") and changed how existing credits can be realized, and enacted various other miscellaneous changes that were effective in fiscal 2017. The Tax Act also established other new tax laws that affect fiscal 2018, including a new limitation on deductible interest expense, limitations on the deductibility of certain executive compensation, limitations on the use of foreign tax credits to reduce the U.S. income tax liability, and limitations on net operating losses (NOLs) generated in tax years beginning after December 31, 2017, to 80% of taxable income.

We are applying the guidance in Staff Accounting Bulletin 118 when accounting for the enactment-date effects of the Act; however, in certain cases, as described below, aspects of our accounting are complete. Additionally, we have made a reasonable estimate of other effects. Currently, we have not adjusted our provisional amounts recorded at February 3, 2018. We will continue to finalize and refine our calculations as additional analysis is completed.

In connection with our initial analysis of the impact of the Tax Act, we recorded a discrete net tax benefit of $0.8 million in the fiscal year ended February 3, 2018. This net tax benefit consisted of a reduction in the valuation allowance by $0.8 million as a result of the elimination of the AMT credit as a deferred tax asset and corresponding establishment of a long-term receivable. During the third quarter the long term receivable was increased by $0.2 million due to an IRS adjustment and related payment of additional alternative minimum tax associated with an ongoing IRS exam.

The Tax Act reduced the corporate rate to 21%, effective January 1, 2018. Our net deferred tax assets and deferred tax liabilities decreased by $35.2 million with a corresponding net adjustment to the valuation allowance for the fiscal year ended February 3, 2018. While we were able to make a reasonable estimate of the impact of the reduction in the corporate rate and valuation allowances, it may be affected by other analyses related to the Tax Act.

Estimates for the applicable various new tax laws effective in fiscal 2018 were included in the second quarter tax provision analysis. Due to our NOLs and valuation allowance, no additional tax provision was recorded due to the Tax Act changes. We will continue to make and refine our calculations as additional information is known and added to the analysis throughout the year.

12

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 7—RELATED-PARTY AGREEMENTS AND TRANSACTIONS

According to publicly available information ESL Investments, Inc. and investment affiliates including Edward S. Lampert (collectively, "ESL") beneficially own 58.8% of our outstanding shares of common stock and more than 50% of Sears Holdings's shares of common stock. ESL also has disclosed that it is a significant Sears Holdings creditor.

The SHO-Sears Holdings Agreements, among other things, (1) govern specified aspects of our relationship with Sears Holdings, (2) establish terms under which subsidiaries of Sears Holdings provide services to us, and (3) establish terms pursuant to which subsidiaries of Sears Holdings obtain merchandise inventories for us. The terms of the SHO-Sears Holdings Agreements were agreed to prior to the Separation (except for amendments entered into after the Separation that were approved by the Audit Committee of SHO's Board of Directors) in the context of a parent-subsidiary relationship and in the overall context of the Separation. The costs and allocations charged to the Company by Sears Holdings do not necessarily reflect the costs of obtaining the services from unaffiliated third parties or of the Company itself providing the applicable services. The Company has engaged in frequent discussions, and has resolved disputes, with Sears Holdings about the terms and conditions of the SHO-Sears Holdings Agreements, the business relationships that are reflected in the SHO-Sears Holdings Agreements, and the details of these business relationships, many of which details had not been addressed by the terms and conditions of the SHO-Sears Holdings Agreements or, if addressed, in the past were, and in the future could be, in dispute as to their meaning or application in the context of the existing business relationships. Many of these discussions have resulted in adjustments to the relationships that the Company believes together are in the Company's best interests.

On October 15, 2018 Sears Holdings and many of its subsidiaries filed voluntary petitions in the United States Bankruptcy Court for the Southern District of New York seeking relief under Chapter 11 of the Bankruptcy Code. Sears Holdings has the right, subject to Bankruptcy Court approval, to reject the SHO-Sears Holdings Agreements to the extent they are determined to be "executory contracts" within the meaning of the Bankruptcy Code. If the SHO-Sears Holdings Agreements were rejected as part of Sears Holdings's reorganization or its liquidation (especially if the liquidation were effected other than through a going concern sale), there is a significant risk that the Company's ability to conduct its businesses (especially the Hometown businesses, given their dependence on purchasing Kenmore and Craftsman branded merchandise and other merchandise from Sears Holdings under the SHO-Sears Holdings Agreements) and the Company's results of operations, financial condition, liquidity, and cash flows could be materially and adversely affected. See Note 1 to these Condensed Consolidated Financial Statements.
The following is a summary of the nature of the related-party transactions between SHO and Sears Holdings:
We obtain a significant amount of our merchandise inventories from Sears Holdings.
We pay royalties related to our sale of products branded with the KCD Marks. The royalty rates vary but none exceeds 6%.
We pay fees for participation in Sears Holdings's SHOP YOUR WAY REWARDS® program.
We pay fees to Sears Holdings for logistics, handling, warehouse, and transportation services, which fees are based generally on merchandise inventory units.
Sears Holdings provides the Company with specified corporate services. These services include accounting and finance, and information technology, among other services. Sears Holdings charges the Company for these corporate services based on actual usage or pro rata charges based upon sales or other measurements.
Sears Holdings leases stores and distribution/repair facilities to the Company, for which the Company pays rent and related occupancy charges to Sears Holdings.
SHO receives commissions from Sears Holdings for specified online sales, sales of extended service contracts, and sales of delivery and handling services, and commissions relating to the use in our stores of credit cards branded with the Sears name. For specified transactions SHO pays commissions to Sears Holdings.

The following table summarizes the results of the transactions with Sears Holdings reflected in the Company’s Condensed Consolidated Financial Statements: 
 
13 Weeks Ended
 
39 Weeks Ended
Thousands
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
Net Commissions from Sears Holdings
$
12,981

 
$
15,548

 
$
44,292

 
$
51,393

Purchases related to cost of sales and occupancy
165,988

 
218,445

 
562,873

 
751,559

Services included in selling and administrative expense
9,571

 
12,150

 
36,820

 
46,053



13

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


We incur payables to Sears Holdings for merchandise inventory purchases and service and occupancy charges (net of commissions) based on the SHO-Sears Holdings Agreements.  Amounts due to or from Sears Holdings are non-interest bearing and, except as provided in the following sentences of this paragraph, are settled on a net basis and have payment terms of 10 days after the invoice date. In accordance with the SHO–Sears Holdings Agreements and at the request of Sears Holdings, the Company can pay invoices early and receive a deduction on invoices for early–payment discounts commensurate with the number of days paid early. The Company and Sears Holdings each can, in its sole discretion, revert to ten–day, no–discount payment terms at any time upon notice to the other. The discounts received for payments made on accelerated terms, net of incremental interest expense, results in a net financial benefit to the Company.

In the third quarter of 2018, we continued our agreement with Sears Holdings whereby SHO paid Sears Holdings's invoices for merchandise and services on accelerated payment terms in exchange for cash discounts until the Sears Holdings Chapter 11 bankruptcy filing. Shortly before the bankruptcy filing, we reverted to our normal ten-day, no-discount payment terms and the Senior ABL Facility borrowings did not increase as of November 3, 2018 as a result of accelerated payments. The Company paid invoices early and received discounts of $0.4 million and $2.1 million for the 13 and 39 weeks ended November 3, 2018, respectively, and $1.1 million and $3.2 million for the 13 and 39 weeks ended October 28, 2017, respectively, which are reflected in the Condensed Consolidated Statements of Operations.

We recorded real estate occupancy payments of $0.1 million and $0.5 million for the 13 and 39 weeks ended November 3, 2018, respectively, and $0.3 million and $0.9 million for the 13 and 39 weeks ended October 28, 2017, respectively, to Seritage Growth Properties ("Seritage"), a real estate investment trust. Edward S. Lampert is the Chairman of the Board of Trustees of Seritage.

NOTE 8—FINANCING ARRANGEMENTS

Senior ABL Facility

In October 2012, the Company entered into a Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent, which provided (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the “Prior Facility”). Under the Prior Facility the Company initially borrowed $100 million which was used to pay a cash dividend to Sears Holdings prior to the Separation.
  
On November 1, 2016, the Company and its primary operating subsidiaries, entered into an Amended and Restated Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent and collateral agent, which provides (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the “Senior ABL Facility”). The Senior ABL Facility, which amended and restated the Prior Facility in its entirety, provides for extended revolving credit commitments of specified lenders in an aggregate amount equal to $170 million (the “Extended Revolving Credit Commitments”) and provided for non-extended revolving credit commitments of specified lenders in an aggregate amount equal to $80 million (the “Non-Extended Revolving Credit Commitments”). The Extended Revolving Credit Commitments will mature on the earliest of the following dates: (1) February 29, 2020; (2) six months prior to the expiration of specified Separation Agreements unless the Separation Agreements are extended to a date later than February 29, 2020 or are terminated on a basis reasonably satisfactory to the Senior ABL lenders; and (3) acceleration of the maturity date following an event of default in accordance with the Senior ABL Facility. See Note 1 to these Condensed Consolidated Financial Statements. The Non-Extended Revolving Credit Commitments matured on October 11, 2017 and the Company repaid in full all outstanding borrowings associated with these commitments. Unamortized debt costs related to the Senior ABL Facility of $2.0 million are included in Prepaid and Other current assets on the Condensed Consolidated Balance Sheet as of November 3, 2018 and are being amortized over the remaining term of the Senior ABL Facility.

As of November 3, 2018, we had $107.0 million outstanding under the Senior ABL Facility. Up to $75 million of the Senior ABL Facility is available for the issuance of letters of credit and up to $25 million is available for swingline loans. The Senior ABL Facility permits us to request commitment increases in an aggregate principal amount of up to $100 million. Availability under the Senior ABL Facility as of November 3, 2018 was $32.0 million, with $7.2 million of letters of credit outstanding under the facility. The ending cash balance as of November 3, 2018 and October 27, 2017, was $43.2 million and $14.0 million, respectively. Availability under the Senior ABL Facility may be reduced from time to time in the discretion of the agent under the Senior ABL Facility by the imposition of reserves against the borrowing base.


14

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The principal terms of the Senior ABL Facility are summarized below. See Note 1 to these Condensed Consolidated Financial Statements and the 2017 10-K for additional information about the terms of our Senior ABL Facility, including conditions to borrowing.

Prepayments

The Senior ABL Facility is subject to mandatory prepayment in amounts equal to the amount by which the outstanding extensions of credit exceed the lesser of the borrowing base and the commitments then in effect. If availability under the Senior ABL Facility is reduced from time to time in the discretion of the agent under the Senior ABL Facility by the imposition of additional reserves against the borrowing base, the Company may be required to make additional prepayments.

Security and Guarantees

The Senior ABL Facility is secured by a first lien security interest on substantially all the assets of the Company and its subsidiaries, including, without limitation, accounts receivable, inventory, general intangibles, investment property, equipment, cash, cash equivalents, deposit accounts and securities accounts, as well as certain other assets (other than intellectual property and fee-owned interests in real property) ancillary to any of the foregoing and all proceeds of any of the foregoing, including cash proceeds and the proceeds of applicable insurance. The Senior ABL Facility is guaranteed by the Company and each of its existing and future direct and indirect wholly owned domestic subsidiaries (other than specified immaterial subsidiaries).

Interest; Fees

The interest rates per annum applicable to the loans under the Senior ABL Facility are based on a fluctuating rate of interest measured by reference to, at the Company’s election, either (1) an adjusted London inter-bank offered rate (LIBOR) plus a borrowing margin ranging from 3.50% to 4.50%, (the rate was approximately 6.25% at November 3, 2018), and in each case based on availability under the Senior ABL Facility, or (2) an alternate base rate plus a borrowing margin, ranging from 2.50% to 3.50% (the rate was approximately 8.25% at November 3, 2018), and in each case based on availability under the Senior ABL Facility.

Customary fees are payable in respect of the Senior ABL Facility, including letter of credit fees and commitment fees.

Covenants

The Senior ABL Facility includes a number of negative covenants that, among other things, limit or restrict the ability of the Company and its subsidiaries (including the guarantors) to, subject to certain exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make dividends or other distributions with respect to, or repurchase, the Company’s capital stock, make prepayments on other indebtedness, engage in mergers, and change the nature of the business of the Company and its subsidiaries (including the guarantors).  The Senior ABL Facility also imposes various other requirements, which take effect if availability falls below designated thresholds or an event of default occurs, including a cash dominion requirement with additional borrowing base reporting requirements in addition to a requirement that a fixed charge ratio, calculated on a trailing twelve-month basis, be not less than 1.0 to 1.0. The Senior ABL Facility also contains affirmative covenants, including financial and other reporting requirements.

Events of Default

The Senior ABL Facility includes customary and other events of default (upon which all amounts outstanding would become immediately due and payable) including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests and other Senior ABL Facility loan documents (including an agreement with the Company, Sears Holdings, and the agents under the Senior ABL Facility and the Term Loan Agreement), material judgments, change of control, failure to perform a “Material Contract” (which includes specified SHO-Sears Holdings Agreements) to the extent required to maintain it in full force and effect, failure to enforce a Material Contract in accordance with its terms, or termination (including as a result of rejection in an insolvency proceeding) by Sears Holdings of "the Separation Agreements” (which include specified SHO-Sears Holdings Agreements) and cessation of business activities in the ordinary course.




15

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Term Loan Agreement

On February 16, 2018 the Company’s three operating subsidiaries, Sears Authorized Hometown Stores, LLC, Sears Home Appliance Showrooms, LLC, and Sears Outlet Stores, L.L.C., as borrowers, and the Company, as guarantor, entered into a Term Loan Credit Agreement with Gordon Brothers Finance Company, as agent, lead arranger, and sole bookrunner, and Gordon Brothers Finance Company, LLC, as lender (the “Term Loan Agreement”). The Term Loan Agreement provides for a $40 million term loan (the “Term Loan”), which amount the Company has borrowed, and is outstanding, in accordance with and subject to the terms and conditions of the Term Loan Agreement. The Company used the proceeds of the Term Loan to pay down borrowings under the Senior ABL Facility. The Term Loan will mature on the earliest of (1) the maturity date specified in the Senior ABL Facility, (2) February 16, 2023, and (3) acceleration of the maturity date following an event of default in accordance with the Term Loan Agreement. See Note 1 to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.

Unamortized debt costs of $1.2 million related to the Term Loan are netted against the Term Loan on the Condensed Consolidated Balance Sheets as of November 3, 2018 and are being amortized over the remaining term of the Term Loan.

The principal terms of the Term Loan Agreement are summarized below.

Security and Guarantees

The Term Loan Agreement is secured by a second lien security interest (subordinate only to the liens securing the Senior ABL Facility) on substantially all the assets of the Company and its subsidiaries (the same assets as the assets securing the Senior ABL Facility), including without limitation accounts receivable, inventory, general intangibles, investment property, equipment, cash, cash equivalents, deposit accounts and securities accounts, as well as other assets (other than intellectual property and fee-owned interests in real property) ancillary to any of the foregoing and all proceeds of any of the foregoing, including cash proceeds and the proceeds of applicable insurance. The Term Loan Agreement is guaranteed by the Company and each of its existing and future direct and indirect wholly owned domestic subsidiaries (other than specified immaterial subsidiaries).

Prepayments

The Term Loan is subject to mandatory prepayment in amounts equal to the amount by which the outstanding Term Loan exceeds the borrowing base specified in the Term Loan Agreement plus a reserve to be maintained against the borrowing base for the Senior ABL Facility (the “push-down reserve”), which reserve will be equal to total outstandings under the Term Loan Agreement that exceed the Term Loan Agreement’s borrowing base, if such excess were to arise. If any additional reserves are imposed by the Senior ABL Facility agent against the borrowing base under the Senior ABL Facility or if, under certain circumstances, the agent under the Term Loan imposes reserves against the borrowing base under the Term Loan Agreement, the Company may be required to make additional prepayments under the Term Loan. The Company may not reborrow amounts prepaid.

Interest; Fees

The interest rate applicable to the Term Loan under the Term Loan Agreement is a fluctuating rate of interest (payable and adjusted monthly) equal to the greater of (1) three-month LIBOR (the rate was approximately 2.59% at November 3, 2018) plus 8.50% per annum and (2) a minimum interest rate of 9.50% per annum. Customary fees are payable in respect of the Term Loan Agreement, including a commitment fee and an early prepayment fee.

Covenants

The Term Loan Agreement includes a number of negative covenants that, among other things, limit or restrict the ability of the Company, the Borrowers, and the Company’s other subsidiaries to, subject to exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make dividends or other distributions with respect to, or repurchase, the Company’s capital stock, make prepayments on other indebtedness, engage in mergers, or change the nature of the business. In addition, upon excess availability falling below a specified level or the occurrence of an event of default the Company would be subject to a cash dominion requirement. The Term Loan Agreement also provides that the Borrowers will not permit availability under the Term Loan Agreement and the Senior ABL Facility to be less than 10% of a combined loan cap.


16

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The Term Loan Agreement also contains affirmative covenants including, among others, financial and other reporting and notification requirements, maintenance of properties, inspection rights, and physical inventories. The Company and the Borrowers also agree that the Company and the Borrowers will cause the push-down reserve to be established and maintained when and if required by the Term Loan Agreement. The Term Loan Agreement borrowing base generally means specified amounts of credit card receivables and inventory (net of reserves), minus the loan cap for the Senior ABL Facility and availability reserves. The borrowing base under the Term Loan Agreement may be further reduced if the agent under the Senior ABL Facility or, under certain circumstances, the agent under the Term Loan elects in their respective applicable discretion to impose additional reserves against the borrowing base under the Senior ABL Facility or the Term Loan.

Events of Default

The Term Loan Agreement includes customary events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties in any material respect, cross default to the Senior ABL Facility and other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of the Term Loan Agreement and the other related loan documents (including the guarantees or security interests provided therein and other Term Loan loan documents (including an agreement with the Company, Sears Holdings, and the agents under the Senior ABL Facility and the Term Loan Agreement)), material judgments, change of control, and failure to perform a “Material Contract” (which includes specified SHO-Sears Holdings Agreements) to the extent required to maintain it in full force and effect, failure to enforce a Material Contract in accordance with its terms, or termination (including as a result of rejection in an insolvency proceeding) by Sears Holdings of "the Separation Agreements” (which include specified SHO-Sears Holdings Agreements) and cessation of business activities in the ordinary course.

NOTE 9—SUMMARY OF SEGMENT DATA
Our two reportable segments are Hometown and Outlet. The Hometown reportable segment consists of the aggregation of our Hometown Stores, Hardware Stores, Home Appliance Showrooms and Buddy's Home Furnishings Stores business formats described in “Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations-Executive Overview" of this Quarterly Report on Form 10-Q. The Outlet business format also represents a reportable segment. These segments are evaluated by our Chief Operating Decision Maker to make decisions about resource allocation and to assess performance. Each of these segments derives its revenues from the sale of merchandise and related services to customers, primarily in the U.S. Sales categories include appliances, lawn and garden, tools and other.
 
 
13 Weeks Ended November 3, 2018
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
155,166

 
$
106,295

 
$
261,461

Lawn and garden
 
33,805

 
3,564

 
37,369

Tools
 
15,681

 
3,221

 
18,902

Other
 
8,039

 
13,344

 
21,383

Total
 
212,691

 
126,424

 
339,115

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
165,049

 
89,235

 
254,284

Selling and administrative
 
55,060

 
30,316

 
85,376

Depreciation and amortization
 
1,173

 
1,226

 
2,399

Gain on sale of assets
 

 
(1,358
)
 
(1,358
)
Total
 
221,282

 
119,419

 
340,701

Operating (loss) income
 
$
(8,591
)
 
$
7,005

 
$
(1,586
)
Total assets
 
$
281,048

 
$
111,843

 
$
392,891

Capital expenditures
 
$
1,119

 
$
371

 
$
1,490

 

17

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


 
 
13 Weeks Ended October 28, 2017
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
188,591

 
$
104,356

 
$
292,947

Lawn and garden
 
40,315

 
4,804

 
45,119

Tools
 
20,575

 
3,167

 
23,742

Other
 
10,473

 
13,678

 
24,151

Total
 
259,954

 
126,005

 
385,959

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
202,473

 
96,798

 
299,271

Selling and administrative
 
64,287

 
28,814

 
93,101

Depreciation and amortization
 
1,175

 
1,827

 
3,002

Total
 
267,935

 
127,439

 
395,374

Operating loss
 
$
(7,981
)
 
$
(1,434
)
 
$
(9,415
)
Total assets
 
$
298,859

 
$
141,939

 
$
440,798

Capital expenditures
 
$
829

 
$
1,567

 
$
2,396


 
 
39 Weeks Ended November 3, 2018
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
526,820

 
$
317,290

 
844,110

Lawn and garden
 
152,804

 
14,443

 
167,247

Tools
 
54,392

 
9,505

 
63,897

Other
 
35,616

 
40,558

 
76,174

Total
 
769,632

 
381,796

 
1,151,428

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
610,408

 
276,759

 
887,167

Selling and administrative
 
187,915

 
81,945

 
269,860

Depreciation and amortization
 
4,379

 
4,407

 
8,786

Gain on sale of assets
 

 
(1,358
)
 
(1,358
)
Total
 
802,702

 
361,753

 
1,164,455

Operating (loss) income
 
$
(33,070
)
 
$
20,043

 
$
(13,027
)
Total assets
 
$
281,048

 
$
111,843

 
$
392,891

Capital expenditures
 
$
4,040

 
$
1,065

 
$
5,105



18

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


 
 
39 Weeks Ended October 28, 2017
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
608,830

 
$
346,876

 
$
955,706

Lawn and garden
 
185,115

 
16,096

 
201,211

Tools
 
70,398

 
10,433

 
80,831

Other
 
40,465

 
45,964

 
86,429

Total
 
904,808

 
419,369

 
1,324,177

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
712,473

 
338,913

 
1,051,386

Selling and administrative
 
214,463

 
104,727

 
319,190

Depreciation and amortization
 
3,920

 
5,990

 
9,910

Total
 
930,856

 
449,630

 
1,380,486

Operating loss
 
$
(26,048
)
 
$
(30,261
)
 
$
(56,309
)
Total assets
 
$
298,859

 
$
141,939

 
$
440,798

Capital expenditures
 
$
3,180

 
$
3,857

 
$
7,037

NOTE 10—COMMITMENTS AND CONTINGENCIES
We are subject to various legal and governmental proceedings arising out of the ordinary course of business, the outcome of which, individually and in the aggregate, in the opinion of management would not have a material adverse effect on our business, financial position, results of operations, or cash flows.

NOTE 11— LOSS PER COMMON SHARE

Basic earnings per share is calculated by dividing net loss by the weighted average number of common shares outstanding for each period. Diluted income per common share also includes the dilutive effect of potential common shares. In the periods where the Company records a net loss the diluted per share amount is equal to the basic per share amount.

The following table sets forth the components used to calculate basic and diluted loss per share attributable to our stockholders.
 
13 Weeks Ended
 
39 Weeks Ended
Thousands except income per common share
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
Basic weighted average shares
22,702

 
22,702

 
22,702

 
22,702

Diluted weighted average shares
22,702

 
22,702

 
22,702

 
22,702

Net loss
$
(4,500
)
 
$
(10,933
)
 
$
(23,195
)
 
$
(61,813
)
 
 
 
 
 
 
 
 
Loss per common share:
 
 
 
 
 
 
 
  Basic
$
(0.20
)
 
$
(0.48
)
 
$
(1.02
)
 
$
(2.72
)
  Diluted
$
(0.20
)
 
$
(0.48
)
 
$
(1.02
)
 
$
(2.72
)

19

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)



NOTE 12—EQUITY

Stock-Based Compensation
Under our stock-based employee compensation plan, referred to as the Company's Amended and Restated 2012 Stock Plan (the "Plan"), there are four million shares of stock reserved for issuance (less stock units that have vested and outstanding stock units that have not yet vested). We are authorized to grant restricted stock, stock units, stock options, and to make other awards pursuant to the Plan.

A total of 14,000 shares of restricted stock were granted under the Plan to an eligible individual in the second quarter of 2015 and were forfeited in the first quarter of 2017.

During 2015 the Company granted a total of 159,475 stock units under the Plan, which were payable solely in cash based on the Nasdaq stock price on the vesting date. As of April 13, 2018, 34,091 stock units had been forfeited and on that date the remaining 125,384 stock units vested in accordance with, and subject to the terms and conditions of, governing stock unit agreements and the Plan.

During 2017 the Company granted a total of 262,788 stock units under the Plan, which are payable solely in cash based on the Nasdaq stock price on the vesting dates. On January 30, 2018, 76,485 of these stock units vested in accordance with, and subject to the terms and conditions of, governing stock unit agreements and the Plan and as of November 3, 2018, 53,889 of these stock units had been forfeited. The remaining 132,414 stock units will vest in two substantially equal installments on January 30 in 2019 and 2020 in accordance with, and subject to the terms and conditions of, governing stock unit agreements, including forfeiture conditions, and the Plan. The fair value of these awards varies based on changes in our Nasdaq stock price at the end of each reporting period.

On January 18, 2018 the Company granted a total of 361,393 stock units under the Plan, which are payable solely in cash based on the Nasdaq stock price on the vesting dates. As of November 3, 2018, 27,412 of these stock units had been forfeited. The remaining 333,981 stock units will vest in three substantially equal installments on January 30 in 2019, 2020 and 2021 in accordance with, and subject to the terms and conditions of, governing stock unit agreements, including forfeiture conditions, and the Plan. The fair value of these awards varies based on changes in our Nasdaq stock price at the end of each reporting period.

The shares of restricted stock referred to above constituted outstanding shares of the Company's common stock. The recipient of the restricted stock grant had full voting and dividend rights with respect to, but was unable to transfer or pledge, the shares of restricted stock prior to the applicable vesting date. The stock units referred to above, which were, and are, payable solely in cash based on the Nasdaq closing price of our common stock on the applicable vesting dates, do not constitute outstanding shares of the Company's common stock. The recipients of the stock unit grants have, with respect to their stock units, no rights to receive the Company's common stock or other securities of the Company, no rights as a stockholder of the Company, no dividend rights, and no voting rights.

We are authorized to grant stock options and to make other awards (in addition to restricted stock and stock units) to eligible participants pursuant to the Plan. The Company has made no stock-option awards under the Plan. We do not currently have a broad-based program that provides for awards under the Plan on an annual basis.

We account for stock-based compensation using the fair value method in accordance with accounting standards regarding share-based payment transactions. During the 13 and 39 weeks ended November 3, 2018 no stock-based compensation expense was recorded.

During the 13 and 39 weeks ended November 3, 2018 we recorded $0.5 million and $1.3 million, respectively, in compensation cost related to the then outstanding stock units and at November 3, 2018 we had $1.4 million in total unrecognized compensation cost, which we expect to recognize over the next approximately 2.25 years.


20

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Share Repurchase Program

On August 28, 2013 the Company's Board of Directors authorized a $25 million repurchase program for the Company's outstanding shares of common stock. The timing and amount of repurchases depend on various factors, including market conditions, the Company's capital position and internal cash generation, and other factors. The Company's repurchase program does not include specific price targets, may be executed through open-market, privately negotiated, and other transactions that may be available, and may include utilization of Rule 10b5-1 plans. The repurchase program does not obligate the Company to repurchase any dollar amount, or any number of shares, of common stock. The repurchase program does not have a termination date, and the Company may suspend or terminate the repurchase program at any time. Shares that are repurchased by the Company pursuant to the repurchase program would be retired and would resume the status of authorized and unissued shares of common stock.
No shares were repurchased during the 39 weeks ended November 3, 2018. At November 3, 2018, we had $12.5 million of remaining authorization under the repurchase program. The Company has not repurchased any shares under the repurchase program since late 2013. The Senior ABL Facility and the Term Loan Agreement each limits the Company’s ability to declare and pay cash dividends and to repurchase its common stock and each would not have permitted the Company to pay cash dividends or to repurchase its common stock as of November 3, 2018.

NOTE 13—STORE CLOSING CHARGES

Accelerated Closed Store Charges

We continue to take proactive steps to reduce costs, make the best use of capital, and improve our profitability by closing, or seeking the closure by dealers of, under-performing stores.

In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rent payments for which we no longer expect to receive any economic benefit are accrued when we cease to use the leased space and have been reduced for estimated sublease income.

Accelerated (prior to lease expiration) store closure costs for the 13 and 39 weeks ended November 3, 2018 and October 28, 2017, respectively, were as follows:
Thousands
Lease Termination Costs (1)
 
Inventory Related (1)
 
Impairment and Accelerated Depreciation (2)
 
Other Charges (3)
 
Total Store Closing Costs
13 weeks ended November 3, 2018
$

 
$
(1,100
)
 
$

 
$
7

 
$
(1,093
)
13 weeks ended October 28, 2017
$
(169
)
 
$
2,614

 
$

 
$
(169
)
 
$
2,276


Thousands
Lease Termination Costs (1)
 
Inventory Related (1)
 
Impairment and Accelerated Depreciation (2)
 
Other Charges (3)
 
Total Store Closing Costs
39 weeks ended November 3, 2018
$
(235
)
 
$
5,556

 
$
774

 
$
531

 
$
6,626

39 weeks ended October 28, 2017
$
8,278

 
$
4,410

 
$
979

 
$
217

 
$
13,884

(1)
Recorded within cost of sales and occupancy in the Condensed Consolidated Statements of Operations. Lease termination costs are net of estimated sublease income, and include the reversal of closed store reserves when a lease agreement is terminated for an amount less than the remaining reserve established for the store.
(2)
Recorded within depreciation and amortization in the Condensed Consolidated Statements of Operations.
(3)
Recorded within selling and administrative in the Condensed Consolidated Statements of Operations.


21

SEARS HOMETOWN AND OUTLET STORES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Closed Store Reserves

The store closing and severance costs reserve included within other current liabilities in the Condensed Consolidated Balance Sheets, consists of the following:
 
39 Weeks Ended
Thousands
 
November 3, 2018
 
October 28, 2017
Store closing and severance costs reserve, beginning of period
 
$
4,655

 
$
7,659

Store closing costs
 
5,852

 
8,495

Payments/utilization
 
(9,378
)
 
(11,322
)
Store closing and severance costs reserve, end of period
 
$
1,129

 
$
4,832


NOTE 14—SALE OF ASSETS

On August 10, 2018, we completed the sale of a property located in Newington, Connecticut. The sale price of the property was $2.8 million net of closing costs, and we recorded a gain on sale of approximately $1.3 million during the third quarter of fiscal 2018.

NOTE 15—SUBSEQUENT EVENT

In November 2018 the Company determined that during the fourth quarter of 2018 it will close, or seek the closure by dealers of, between 80 to 100 Hometown stores to continue the Company's efforts to reduce costs, make the best use of capital, and improve the Company's profitability. The closings are expected to result in a one-time charge of between $4.5 million and $6.0 million during the fourth quarter of 2018 for inventory markdowns and write-offs and other store-closing costs.

22

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and notes contained in this Quarterly Report on Form 10-Q and the Consolidated Financial Statements and notes contained in our Annual Report on Form 10-K for the fiscal year ended February 3, 2018 (the "2017 10-K"). This discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. See “Cautionary Statements Regarding Forward-Looking and Other Information” in this Quarterly Report on Form 10-Q and "Item 1A. Risk Factors" in the 2017 10-K for discussions of the uncertainties and the risks to which forward-looking statements are subject. Those uncertainties and risks could also have a material adverse effect on our results of operations, financial condition, liquidity, cash flows, and overall ability to operate our businesses (especially the Hometown businesses, given their dependence on purchasing Kenmore and Craftsman branded merchandise and other merchandise from Sears Holdings under the SHO-Sears Holdings Agreements).

Executive Overview

We are a national retailer primarily focused on selling home appliances, lawn and garden equipment, and tools. As of November 3, 2018, we or our dealers and franchisees operated a total of 761 stores across 49 states, Puerto Rico, and Bermuda. In the third quarter, the Company opened three stores and closed 25 stores of which 11 were in the process of closing and related store closing charges were recorded during the second quarter.

In addition to merchandise, we provide our customers with access to a suite of services, including home delivery, installation, and extended service contracts as well as access to financing through credit card and leasing programs made available by unaffiliated providers. The extended service contracts we offer are issued by Sears Holdings or its third-party service provider. During the third quarter, Sears Holdings's ability to issue extended service contracts was suspended for a portion of fiscal October by regulators in 33 states and Puerto Rico due to Sears Holdings's bankruptcy filing (which is described below) and during the suspension period we were unable to offer and sell extended service contracts issued by Sears Holdings.

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, tools, lawn and garden equipment, sporting goods, and household goods, depending on the format. Our Outlet stores are designed to provide our customers with in-store and online access to purchase, at prices that are significantly lower than list prices, new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked, and scratched and dented products across a broad assortment of merchandise categories, including home appliances, lawn and garden equipment, furniture, mattresses, sporting goods, and tools.

As of November 3, 2018 Hometown consisted of 632 stores as follows:

581 Sears Hometown Stores—Primarily independently operated stores, predominantly located in smaller communities and offering appliances, lawn and garden equipment, and hardware. Most of our Sears Hometown Stores carry Kenmore, Craftsman, and DieHard brand products as well as a wide assortment of other national brand products.
15 Sears Hardware Stores—Stores that carry Craftsman brand tools and lawn and garden equipment, DieHard brand batteries, and a wide assortment of other national brands and other home improvement products along with a selection of Kenmore and other national brands of home appliances.
28 Sears Home Appliance Showrooms—Stores that have a simple, primarily appliance showroom design that are positioned in metropolitan areas.
8 Buddy's Home Furnishings Stores - Stores where we are a franchisee, enabling us to benefit from Buddy's expertise and systems infrastructure in the rent-to-own business in which we own the inventory that we rent to our customers.

As of November 3, 2018, Hometown consisted of 579 dealer-operated stores, 19 franchisee-operated stores, and 34 Company-operated stores. The Company requires all dealer and franchisee-operated stores to operate according to the Company’s standards to protect and enhance the quality of its brands. These stores must display the required merchandise, offer all required products and services, and use the Company’s point-of-sale system. Also, the Company has the right to approve advertising and promotional and marketing materials and imposes certain advertising requirements. The Company owns the merchandise offered for sale by all dealer and franchisee-operated stores, establishes all selling prices for the merchandise, and bears general inventory risk (with specific exceptions) until sale of the merchandise and if the customer returns the merchandise. In addition, because each transaction is recorded in the Company’s point-of-sale system, the Company bears customer credit risk. The Company establishes a commission

23

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017

structure for stores operated by our dealers and franchisees and pays commissions to them when they sell the Company's merchandise and provide services.

As of November 3, 2018, five of the 129 Outlet stores were operated by franchisees and the rest were operated by the Company.

Dealers and franchisees exercise control over the day-to-day operations of their stores, make capital decisions regarding their stores, and exclusively make all hiring, compensation, benefits, termination, and other decisions regarding the terms and conditions of employment, and exclusively establish all employment policies, procedures, and practices with respect to employees.

Several of the primary differences between Company-operated stores and dealer or franchisee-operated stores are that (1) the Company is responsible for occupancy and payroll costs associated with Company-operated stores while dealers and franchisees are responsible for these costs for their stores, (2) the Company is responsible for all terms and conditions of employment for the employees in the Company-operated stores and its dealers and franchisees are responsible for all terms and conditions of employment for the employees in their stores, and (3) we pay commissions to our dealers and franchisees.

In the normal course of business, stores can transition from Company operated to franchisee or dealer operated, and vice-versa. Potential new stores may be identified by the Company, an existing dealer or franchisee, or a potential dealer or franchisee. If the Company identifies and develops a new store, the Company will generally seek to transfer that store to a dealer or a franchisee unless the store is an Outlet store, which the Company would currently intend to keep as a Company-operated store. When a dealer or a franchisee ceases to operate a store, the Company may take over its operation, generally on an interim basis, until the Company can transfer the store to another dealer or franchisee. At any given time the Company is generally operating a number of stores that are in transition from one dealer or franchisee to another dealer or franchisee. Transition stores are not included in our count of Company-operated stores due to the expected short-term nature of transition operation.

The Company's transfer of a Company-operated store to a franchisee historically has (1) in most instances increased the Company's gross margin primarily due to decreased occupancy costs and (2) increased the Company's selling and administrative expense primarily due to increased commission payments, offset partially by lower payroll and benefits expense.

On October 15, 2018 and thereafter Sears Holdings and many of its subsidiaries filed voluntary petitions in the United States Bankruptcy Court for the Southern District of New York seeking relief under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code"). Sears Holdings and the Company (or their respective subsidiaries) are parties to various agreements (as amended, the "SHO-Sears Holdings Agreements") that, among other things, (1) govern specified aspects of the Company's relationship with Sears Holdings, (2) establish terms under which subsidiaries of Sears Holdings provide services to the Company, and (3) establish terms pursuant to which subsidiaries of Sears Holdings obtain merchandise inventories for the Company. Sears Holdings has the right, subject to Bankruptcy Court approval, to reject the SHO-Sears Holdings Agreements to the extent they are determined to be "executory contracts" within the meaning of the Bankruptcy Code. Sears Holdings has not disclosed whether it will seek to reject the SHO-Sears Holdings Agreements. If the SHO-Sears Holdings Agreements were rejected as part of Sears Holdings's reorganization or its liquidation (especially if the liquidation were effected other than through a going concern sale), there is a significant risk that the Company's ability to conduct its businesses (especially the Hometown businesses, given their dependence on purchasing Kenmore and Craftsman branded merchandise and other merchandise from Sears Holdings under the SHO-Sears Holdings Agreements) and the Company's results of operations, financial condition, liquidity, and cash flows could be materially and adversely affected. See Note 1 and Note 7 to the Condensed Consolidated Financial Statements included as part of this Quarterly Report on Form 10-Q and “Cautionary Statements Regarding Forward-Looking and Other Information” in this Item 2 of this Quarterly Report on Form 10-Q.

Merchandise Subsidies and Cash Discounts from Sears Holdings

In accordance with our Amended and Restated Merchandising Agreement with Sears Holdings, 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"). During the first three quarters of 2018 Sears Holdings's Vendor Funds were lower compared to the first three quarters of 2017 and SHO's portion of the collected Vendor Funds during the first three quarters of 2018 were approximately $8.5 million lower than SHO's portion for the first three quarters of 2017. We recorded a receivable of $1.2 million during the third quarter related to funds due to us at the time of the Sears Holdings bankruptcy filing that were not subsequently paid to us. The receivable has been fully reserved due to the uncertain recovery of unsecured claims in the Sears Holdings bankruptcy proceedings. While we cannot

24

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017

provide any assurance that SHO's portion of Vendor Funds collected by Sears Holdings will not decline, stay the same, or increase, we expect our portion will continue to decline in the fourth quarter of 2018 due to an expected increase in our purchases through our direct vendor relationships. If SHO's portion of Vendor Funds collected by Sears Holdings were to decline to a significantly greater extent than SHO's purchases through Sears Holdings, SHO's results of operations could be adversely affected to a material extent.

Home Office Overhead Allocation

Since the Separation we have included an allocation of Home Office overhead expenses in selling and administrative expenses for Hometown and Outlet. Home Office overhead expenses are primarily comprised of corporate headquarters payroll, benefits, and other costs and include charges related to our Services Agreement with Sears Holdings.

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. See Note 9 to the Consolidated Financial Statements included in the 2017 10-K for our quarterly financial results (unaudited) for 2017.

Results of Operations

The following table sets forth items derived from our Condensed Consolidated Statements of Operations for the 13 and 39 weeks ended November 3, 2018 and October 28, 2017.
 
 
13 Weeks Ended
 
39 Weeks Ended
Thousands
 
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
NET SALES
 
$
339,115

 
$
385,959

 
$
1,151,428

 
$
1,324,177

COSTS AND EXPENSES
 
 
 
 
 
 
 
 
Cost of sales and occupancy
 
254,284

 
299,271

 
887,167

 
1,051,386

Selling and administrative
 
85,376

 
93,101

 
269,860

 
319,190

Selling and administrative expense as a percentage of net sales
 
25.2
%
 
24.1
%
 
23.4
%
 
24.1
%
Depreciation and amortization
 
2,399

 
3,002

 
8,786

 
9,910

Gain on sale of assets
 
(1,358
)
 

 
(1,358
)
 

Total costs and expenses
 
340,701

 
395,374

 
1,164,455

 
1,380,486

Operating loss
 
(1,586
)
 
(9,415
)
 
(13,027
)
 
(56,309
)
Interest expense
 
(3,601
)
 
(2,149
)
 
(10,657
)
 
(5,614
)
Other income
 
93

 
194

 
349

 
744

Loss before income taxes
 
(5,094
)
 
(11,370
)
 
(23,335
)
 
(61,179
)
Income tax (expense) benefit
 
594

 
437

 
140

 
(634
)
NET LOSS
 
$
(4,500
)
 
$
(10,933
)
 
$
(23,195
)
 
$
(61,813
)
 
 
 
 
 
 
 
 
 
Gross Margin
 
$
84,831

 
$
86,688

 
$
264,261

 
$
272,791

Margin rate
 
25.0
%
 
22.5
%
 
23.0
%
 
20.6
%

Comparable Store Sales

Comparable store sales include merchandise sales for all stores operating for a period of at least 12 full months, including remodeled and expanded stores but excluding store relocations and stores that have undergone format changes.  Comparable store sales include online transactions fulfilled and recorded by SHO and give effect to the change in the unshipped sales reserves recorded at the end of each reporting period. 

25

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017


Net Loss

We recorded a net loss of $4.5 million for the third quarter of 2018 compared to a net loss of $10.9 million for the prior-year comparable quarter. The decrease in our net loss was primarily attributable to the factors discussed below in this Item 2.

Adjusted EBITDA

In addition to our net loss determined in accordance with GAAP, for purposes of evaluating operating performance we also use adjusted earnings before interest, taxes, depreciation and amortization, or “adjusted EBITDA,” which excludes certain significant items as set forth and discussed below. Our management uses adjusted EBITDA, among other factors, for evaluating the operating performance of our business for comparable periods. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as it excludes a number of important cash and non-cash recurring items. Adjusted EBITDA should not be considered as a substitute for GAAP measurements.

While adjusted EBITDA is a non-GAAP measurement, we believe it is an important indicator of operating performance for investors because:

EBITDA excludes the effects of financing and investing activities by eliminating the effects of interest and depreciation and amortization costs; and
Other significant items, while periodically affecting our results, may vary significantly from period to period and may have a disproportionate effect in a given period, which affects comparability of results. These items may also include cash charges such as investments in our IT transformation (which we have described below in "Analysis of Financial Condition-IT Transformation") and severance and executive transition costs that make it difficult for investors to assess the Company's core operating performance.

The Company has undertaken an initiative on a limited number of occasions to accelerate the closing of under-performing stores in an effort to improve profitability and make the most productive use of capital. Under-performing stores are typically closed during the normal course of business at the termination of a lease or expiration of a franchise or dealer agreement and, as a result, do not have significant future lease, severance, or other non-recurring store-closing costs. When we close a significant number of stores or close them on an accelerated basis (closing prior to lease termination or expiration), the Company excludes the associated costs of the closings from adjusted EBITDA.

The following table presents a reconciliation of adjusted EBITDA to net loss, the most comparable GAAP measure, for each of the periods indicated:
 
 
13 Weeks Ended
 
39 Weeks Ended
Thousands
 
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
Net loss
 
$
(4,500
)
 
$
(10,933
)
 
$
(23,195
)
 
$
(61,813
)
Income tax (benefit) expense
 
(594
)
 
(437
)
 
(140
)
 
634

Other income
 
(93
)
 
(194
)
 
(349
)
 
(744
)
Interest expense
 
3,601

 
2,149

 
10,657

 
5,614

Operating loss
 
(1,586
)
 
(9,415
)
 
(13,027
)
 
(56,309
)
Depreciation and amortization
 
2,399

 
3,002

 
8,786

 
9,910

Gain on sale of assets
 
(1,358
)
 

 
(1,358
)
 

Provision for franchisee note losses, net of recoveries
 
2,923

 
119

 
2,911

 
5,820

IT transformation investments
 
6,076

 
7,799

 
18,317

 
25,517

Accelerated closure of under-performing stores
 
(1,093
)
 
2,276

 
5,852

 
12,905

Adjusted EBITDA
 
$
7,361

 
$
3,781

 
$
21,481

 
$
(2,157
)


26

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017


13-Week Period Ended November 3, 2018 Compared to the 13-Week Period Ended October 28, 2017

Net Sales

Net sales in the third quarter of 2018 decreased $46.8 million, or 12.1%, to $339.1 million from the third quarter of 2017. This decrease was driven primarily by the impact of closed stores (net of new store openings) and by a 0.2% decrease in comparable store sales. Comparable store sales were down 3.4% in Hometown and up 5.7% in Outlet. The lawn and garden category outperformed the average comparable store sales and the tools, home appliances and mattress categories underperformed the average.

Gross Margin

Gross margin was $84.8 million, or 25.0% of net sales, in the third quarter of 2018 compared to $86.7 million, or 22.5% of net sales, in the third quarter of 2017. The increase in gross margin rate was primarily driven by lower accelerated store closing costs (a benefit of $1.1 million in the third quarter of 2018 compared to a $2.3 million charge in the third quarter of 2017), higher margin on merchandise sales, and lower shrink from favorable physical inventory results. The combined impact of accelerated store closing costs and shrink on the gross margin rate was an increase of 76 basis points in the third quarter of 2018 and a reduction of 85 basis points in the third quarter of 2017.

Selling and Administrative Expenses

Selling and administrative expenses decreased to $85.4 million, or 25.2% of net sales, in the third quarter of 2018 from $93.1 million, or 24.1% of net sales, in the prior-year comparable quarter. The dollar decrease was primarily due to lower expenses from stores closed (net of new store openings), lower commissions paid to dealers and franchisees on lower sales volume, and lower IT transformation investments. These reductions were partially offset by higher provisions related to franchisee notes receivables ($2.9 million in the third quarter of 2018 compared to $0.1 million in the third quarter of 2017), higher payroll and benefits due to a higher proportion of Company-operated stores, higher incentive compensation and higher marketing costs. IT transformation investments were $6.1 million, or 1.8% of sales, in the third quarter of 2018 compared to $7.8 million, or 2.0% of sales, in the third quarter of 2017.

Gain on Sale of Assets

During the third quarter of 2018, we completed the sale of an owned property located in Newington, Connecticut. Net proceeds from the sale were $2.8 million, and we recorded a gain on sale of $1.3 million.

Operating Loss

We recorded operating losses of $1.6 million and $9.4 million during the third quarters of 2018 and 2017, respectively. The decrease in operating loss was due to a higher gross margin rate and lower selling and administrative expenses partially offset by lower volume.

Income Taxes

An income tax benefit of $0.6 million and $0.4 million was recorded in the third quarters of 2018 and 2017, respectively. The effective tax rate was 11.66% in the third quarter of 2018 and 3.84% in the third quarter of 2017.

Net Loss

We recorded a net loss of $4.5 million for the third quarter of 2018 compared to a net loss of $10.9 million for the prior-year comparable quarter. The decrease in our net loss was primarily attributable to the factors discussed above partially offset by higher interest expense.

27

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017


39-Week Period Ended November 3, 2018 Compared to the 39-Week Period Ended October 28, 2017

Net Sales

Net sales in the first three quarters of 2018 decreased $172.7 million, or 13.0%, to $1,151.4 million, from the first three quarters of 2017. This decrease was driven primarily by the impact of closed stores (net of new store openings) and a 3.7% decrease in comparable store sales. Comparable store sales were down 4.3% and 2.4% in Hometown and Outlet, respectively. The home appliances and mattress categories outperformed the average comparable store sales, and the lawn and garden and tools categories underperformed the average.

Gross Margin

Gross margin was $264.3 million, or 23.0% of net sales, in the first three quarters of 2018 compared to $272.8 million, or 20.6% of net sales, in the first three quarters of 2017. The increase in gross margin rate was primarily driven by higher margin on merchandise sales and lower accelerated store closing costs ($5.9 million in the first three quarters of 2018 compared to $12.9 million in the first three quarters of 2017). These improvements were partially offset by an increase in occupancy costs as a percent of sales. The combined impact of occupancy costs and accelerated store closing costs on the gross margin rate was a reduction of 447 basis points in the first three quarters of 2018 and a reduction of 462 basis points in the first three quarters of 2017.

Selling and Administrative Expenses

Selling and administrative expenses decreased to $269.9 million, or 23.4% of net sales, in the first three quarters of 2018 from $319.2 million, or 24.1% of net sales, in the prior-year comparable period. The dollar decrease was primarily due to lower commissions paid to dealers and franchisees on lower sales volume, lower expenses from stores closed (net of new store openings), lower IT transformation investments, and lower provisions related to franchisee receivables ($2.9 million in the first three quarters of 2018 compared to $5.8 million in the first three quarters of 2017). IT transformation investments were $18.3 million, or 1.6% of net sales, in the first three quarters of 2018 compared to $25.5 million, or 1.9% of net sales, in the first three quarters of 2017.

Gain on Sale of Assets

During the third quarter of 2018, we completed the sale of an owned property located in Newington, Connecticut. Net proceeds from the sale were $2.8 million, and we recorded a gain on sale of $1.3 million.

Operating Loss

We recorded operating losses of $13.0 million and $56.3 million for the first three quarters of 2018 and 2017, respectively. The decrease in operating loss was due to lower selling and administrative expenses and a higher gross margin rate partially offset by lower volume.

Income Taxes

An income tax benefit (expense) of $0.1 million and $(0.6) million was recorded in the first three quarters of 2018 and 2017, respectively. The effective tax rate was 0.60% in the first three quarters of 2018 and (1.04)% in the first three quarters of 2017.

Net Loss

We recorded a net loss of $23.2 million for the first three quarters of 2018 compared to a net loss of $61.8 million for the prior-year comparable period. The decrease in our net loss was primarily attributable to the factors discussed above partially offset by higher interest expense.


28

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017

Business Segment Results

Hometown

Hometown results and key statistics were as follows:
 
13 Weeks Ended
 
39 Weeks Ended
Thousands, except for number of stores
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
NET SALES
$
212,691

 
$
259,954

 
$
769,632

 
$
904,808

Comparable store sales %
(3.4
)%
 
(9.9
)%
 
(4.3
)%
 
(7.5
)%
COSTS AND EXPENSES
 
 
 
 
 
 
 
Cost of sales and occupancy
165,049

 
202,473

 
610,408

 
712,473

Selling and administrative
55,060

 
64,287

 
187,915

 
214,463

Selling and administrative expense as a percentage of net sales
25.9
 %
 
24.7
 %
 
24.4
 %
 
23.7
 %
Depreciation and amortization
1,173

 
1,175

 
4,379

 
3,920

Total costs and expenses
221,282

 
267,935

 
802,702

 
930,856

Operating loss
$
(8,591
)
 
$
(7,981
)
 
$
(33,070
)
 
$
(26,048
)
 
 
 
 
 
 
 
 
Gross margin dollars
47,642

 
57,481

 
159,224

 
192,335

Margin rate
22.4
 %
 
22.1
 %
 
20.7
 %
 
21.3
 %
 
 
 
 
 
 
 
 
Total Hometown stores
 
 
 
 
632

 
784


13-Week Period ended November 3, 2018 Compared to the 13-Week Period Ended October 28, 2017

Net Sales

Hometown net sales in the third quarter of 2018 decreased $47.3 million, or 18.2%, to $212.7 million from the third quarter of 2017. The decrease was primarily due to the impact of closed stores and a 3.4% decrease in comparable store sales. The lawn and garden category outperformed the average comparable store sales, posting positive comparable store sales for the quarter. Tools outperformed the average, and the home appliances and mattress categories underperformed the average.

Gross Margin

Gross margin was $47.6 million, or 22.4% of net sales, in the third quarter of 2018 compared to $57.5 million, or 22.1% of net sales, in the third quarter of 2017. The increase in gross margin rate was primarily driven by reduced store closing costs, shrink favorability and lower occupancy costs. These increases were mostly offset by a reduction in gross margin on merchandise sales due to lower shared Vendor Funds collected by Sears Holdings. The impact of closing store costs, shrink, and occupancy costs on the gross margin rate was a 44 basis points increase in the third quarter of 2018 compared to a 258 basis points decrease in the third quarter of 2017.

Selling and Administrative Expenses

Selling and administrative expenses decreased to $55.1 million, or 25.9% of net sales, in the third quarter of 2018 from $64.3 million, or 24.7% of net sales, in the prior-year comparable quarter. The decrease was primarily due to lower expenses from store closures (net of new store openings), lower commissions paid to dealers and franchisees on lower sales volume, and reduced IT transformation costs. IT transformation investments were $4.2 million, or 2.0% of net sales, in the third quarter of 2018 compared to $5.2 million, or 2.0%, of net sales, in the third quarter of 2017.



29

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017

Operating Loss

We recorded operating losses of $8.6 million and $8.0 million in the third quarters of 2018 and 2017, respectively. The increase in operating loss was primarily due to lower volume partially offset by lower selling and administrative expenses.

Adjusted EBITDA

The following table presents a reconciliation of our Hometown segment's adjusted EBITDA to operating loss, the most comparable GAAP measure for our Hometown segment, for each of the periods indicated:
 
 
13 Weeks Ended
 
39 Weeks Ended
Thousands
 
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
Operating loss
 
$
(8,591
)
 
$
(7,981
)
 
$
(33,070
)
 
$
(26,048
)
Depreciation and amortization
 
1,173

 
1,175

 
4,379

 
3,920

Provision for franchisee note losses, net of recoveries
 
(38
)
 
(74
)
 
(149
)
 
(108
)
IT transformation investments
 
4,207

 
5,187

 
12,683

 
16,966

Accelerated closure of under-performing stores
 
(1,141
)
 
2,448

 
6,111

 
5,836

Adjusted EBITDA
 
$
(4,390
)
 
$
755

 
$
(10,046
)
 
$
566


See "Management’s Discussion and Analysis of Financial Condition and Results of Operations-Adjusted EBITDA" in this Item 2 regarding why we believe that presentation of adjusted EBITDA, a non-GAAP financial measure, provides useful information to investors regarding the Company's financial condition and results of operations and how we use adjusted EBITDA.

39-Week Period ended November 3, 2018 Compared to the 39-Week Period Ended October 28, 2017

Net Sales

Hometown net sales in the first three quarters of 2018 decreased $135.2 million, or 14.9%, to $769.6 million from the first three quarters of 2017. The decrease was primarily due to the impact of closed stores (net of new stores) and a 4.3% comparable store sales decrease. Home appliances outperformed the average comparable store sales while the lawn and garden, tools and mattress categories all underperformed the average comparable store sales.

Gross Margin

Gross margin was $159.2 million, or 20.7% of net sales, for the first three quarters of 2018 compared to $192.3 million, or 21.3% of net sales, for the first three quarters of 2017. The decrease in gross margin rate was primarily driven by lower margin on merchandise sales and higher closing store costs partially offset by favorable shrink and lower occupancy costs. The impact of closing store costs, shrink, and occupancy costs on the gross margin rate was a 169 basis points decrease in the first three quarters of 2018 compared to a 207 basis points decrease in the first three quarters of 2017.

Selling and Administrative Expenses

Selling and administrative expenses decreased to $187.9 million, or 24.4% of net sales, in the first three quarters of 2018 from $214.5 million, or 23.7% of net sales, in the prior-year comparable period. The dollar decrease primarily resulted from lower expenses due to store closures (net of new store openings), lower commissions paid to dealers and franchisees on lower sales volume, and reduced IT transformation costs. These decreases were partially offset by higher payroll and benefits. IT transformation investments were $12.7 million, or 1.6% of sales, in the first three quarters of 2018 compared to $17.0 million, or 1.9% of sales, in the first three quarters of 2017.

Operating Loss

We recorded operating losses of $33.1 million and $26.0 million in the first three quarters of 2018 and 2017, respectively. The increase in operating loss was primarily due to lower volume and a lower gross margin rate partially offset by lower selling and administrative expenses.

30

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017

Outlet

Outlet results and key statistics were as follows:
 
 
13 Weeks Ended
 
39 Weeks Ended
Thousands, except for number of stores
 
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
NET SALES
 
$
126,424

 
$
126,005

 
$
381,796

 
$
419,369

Comparable store sales %
 
5.7
%
 
(5.0
)%
 
(2.4
)%
 
(6.8
)%
COSTS AND EXPENSES
 
 
 
 
 
 
 
 
Cost of sales and occupancy
 
89,235

 
96,798

 
276,759

 
338,913

Selling and administrative
 
30,316

 
28,814

 
81,945

 
104,727

Selling and administrative expense as a percentage of net sales
 
24.0
%
 
22.9
 %
 
21.5
 %
 
25.0
 %
Depreciation and amortization
 
1,226

 
1,827

 
4,407

 
5,990

Gain on sale of assets
 
(1,358
)
 

 
(1,358
)
 

Total costs and expenses
 
119,419

 
127,439

 
361,753

 
449,630

Operating income (loss)
 
$
7,005

 
$
(1,434
)
 
$
20,043

 
$
(30,261
)
 
 
 
 
 
 
 
 
 
Gross margin dollars
 
37,189

 
29,207

 
105,037

 
80,456

Margin rate
 
29.4
%
 
23.2
 %
 
27.5
 %
 
19.2
 %
 
 
 
 
 
 
 
 
 
Total Outlet stores
 
 
 
 
 
129

 
137


13-Week Period ended November 3, 2018 Compared to the 13-Week Period Ended October 28, 2017

Net Sales

Outlet net sales in the third quarter of 2018 increased $0.4 million, or 0.3%, to $126.4 million from the third quarter of 2017. This increase was driven primarily by a 5.7% increase in comparable store sales. The home appliances, tools, mattress, and furniture categories outperformed the average comparable store sales. The lawn and garden category underperformed the average.

Gross Margin

Gross margin was $37.2 million, or 29.4% of net sales, in the third quarter of 2018 compared to $29.2 million, or 23.2% of net sales, in the third quarter of 2017. The increase in gross margin rate was primarily driven by higher margin on merchandise sales.

Selling and Administrative Expenses

Selling and administrative expenses increased to $30.3 million, or 24.0% of net sales, in the third quarter of 2018 from $28.8 million, or 22.9% of net sales, in the prior-year comparable quarter. The increase was primarily due to higher provisions related to franchisee receivables ($3.0 million in the third quarter of 2018 compared to $0.2 million in the third quarter of 2017), higher marketing expenses, and higher payroll and benefits. These increases were partially offset by lower commissions paid to franchisees on lower franchise store count, lower expenses from stores closed (net of new store openings), and lower IT transformation investments. IT transformation investments were $1.9 million, or 1.5% of net sales, in the third quarter of 2018 compared to $2.6 million, or 2.1% of net sales, in the third quarter of 2017.

Gain on Sale of Assets

During the third quarter of 2018, we completed the sale of an owned property located in Newington, Connecticut. Net proceeds from the sale were $2.8 million, and we recorded a gain on sale of $1.3 million.


31

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 39 Weeks Ended November 3, 2018 and October 28, 2017

Operating Income (Loss)

We recorded operating income of $7.0 million in the third quarter of 2018 and an operating loss of $1.4 million in the third quarter of 2017. The increase in operating income was due to a higher gross margin rate partially offset by higher selling and administrative expenses.

Adjusted EBITDA

The following table presents a reconciliation of our Outlet segment's adjusted EBITDA to operating income (loss), the most comparable GAAP measure for our Outlet segment, for each of the periods indicated:
 
 
13 Weeks Ended
 
39 Weeks Ended
Thousands
 
November 3, 2018
 
October 28, 2017
 
November 3, 2018
 
October 28, 2017
Operating income (loss)
 
$
7,005

 
$
(1,434
)
 
$
20,043

 
$
(30,261
)
Depreciation and amortization
 
1,226

 
1,827

 
4,407

 
5,990

Gain on sale of assets
 
(1,358
)
 

 
(1,358
)
 

Provision for franchisee note losses, net of recoveries
 
2,961