Description
Sears Holdings Corporation. Director, 10% Owner EDWARD S LAMPERT bought 2,399,824 shares on 9-04-2012 at $ 52.75
BUSINESS OVERVIEW
Business Segments
During 2011, we operated three reportable segments: Kmart, Sears Domestic and Sears Canada. Financial information, including revenues, operating income (loss), total assets and capital expenditures for each of these business segments is contained in Note 17 of Notes to Consolidated Financial Statements. Information regarding the components of revenue for Holdings is included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as Note 17.
Kmart
At January 28, 2012, Holdings operated a total of 1,305 Kmart stores across 49 states, Guam, Puerto Rico, and the U.S. Virgin Islands. This store count consists of 1,279 discount stores, averaging 94,000 square feet, and 26 Super Centers, averaging 169,000 square feet, and includes 60 Kmart stores that we plan to close in the first half of 2012. Most Kmart stores are one-floor, free-standing units that carry a wide array of products across many merchandise categories, including consumer electronics, seasonal merchandise, outdoor living, toys, lawn and garden equipment, food and consumables and apparel, including products sold under such well-known labels as Jaclyn Smith and Joe Boxer, and certain proprietary Sears brand products (such as Kenmore, Craftsman, and DieHard) and services. Beginning in 2011, we now offer an assortment of major appliances, including Kenmore-branded products, in virtually all of our locations. There are 978 Kmart stores that also operate in-store pharmacies. The Super Centers generally operate 24 hours a day and combine a full-service grocery along with the merchandise selection of a discount store. There are also 22 Sears Auto Centers operating in Kmart stores. Sears Auto Centers offer a variety of professional automotive repair and maintenance services, as well as a full assortment of automotive accessories. Kmart continues to offer its layaway program, which allows customers to cost-effectively finance their purchases. In addition, we have expanded the ways our customers can receive their purchases, allowing our customers to buy online and pick up in store. This service, powered by MyGofer, is now available in over 900 Kmart stores via either myGofer.com or kmart.com. Kmart also sells its products through its kmart.com website.
Spin-Off of Orchard Supply Hardware Stores Corporation
On December 30, 2011, we completed the spin-off to our shareholders of all of the capital stock of Orchard Supply Hardware Stores Corporation (“Orchard”) that was owned by Holdings immediately prior to the spin-off, consisting of common stock that represented approximately 80% of the voting power of Orchard’s outstanding capital stock and preferred stock that represented 100% of Orchard’s outstanding nonvoting capital stock. We expect that the spin-off will be tax-free to Holdings’ shareholders for U.S. federal income tax purposes, except for any cash received in lieu of shares. In connection with the spin-off, Holdings and certain of its subsidiaries entered into various agreements with Orchard, including a distribution agreement, a transition services agreement, an appliance sale and consignment agreement and brand license agreements. In addition, certain tax matters between Holdings and Orchard are governed by a tax sharing agreement entered into in 2005.
Acquisition of Noncontrolling Interest in Sears Canada
During 2010 and 2009, we acquired approximately 19 million and 0.5 million, respectively, of Sears Canada’s common shares in open market transactions. We paid a total of $560 million and $7 million, respectively, for the additional shares and accounted for the acquisitions of additional interest in Sears Canada as an equity transaction in accordance with accounting standards on noncontrolling interests. Accordingly, we reclassified an accumulated other comprehensive loss from noncontrolling interest to controlling interest in the Consolidated Statement of Equity.
At January 28, 2012, January 29, 2011, and January 30, 2010, Sears Holdings was the beneficial holder of approximately 97 million, or 95%, 97 million, or 92% and 79 million or 73%, respectively, of the common shares of Sears Canada.
Real Estate Transactions
In the normal course of business, we consider opportunities to purchase leased operating properties, as well as offers to sell owned, or assign leased, operating and non-operating properties. These transactions may, individually or in the aggregate, result in material proceeds or outlays of cash. In addition, we review leases that will expire in the short term in order to determine the appropriate action to take with respect to them.
As noted on February 23, 2012, the Company entered into an agreement with General Growth Properties to sell eleven properties (6 owned and 5 leased) for $270 million in net cash proceeds. We expect to close this transaction in April 2012.
As noted on March 2, 2012, Sears Canada, a consolidated, 95%-owned subsidiary of Sears, entered into an agreement with The Cadillac Fairview Corporation Limited to surrender and early terminate the leases on three properties for $170 million Canadian in cash proceeds. The transaction is expected to close in April 2012.
Further information concerning our real estate transactions is contained in Notes 11 and 21 of Notes to Consolidated Financial Statements.
Trademarks, Trade Names and Licenses
The KMART ® and SEARS ® trade names, service marks and trademarks, used by us both in the United States and internationally, are material to our retail and other related businesses.
We sell proprietary branded merchandise under a number of brand names that are important to our operations. Our KENMORE ® , CRAFTSMAN ® , DIEHARD ® and LANDS’ END ® brands are among the most recognized proprietary brands in retailing. These marks are the subject of numerous United States and foreign trademark registrations. Other well recognized Company trademarks and service marks include APOSTROPHE ® , CANYON RIVER BLUES ® , COVINGTON ® , BASIC EDITIONS ® , SHOPYOURWAY ® and SMART SENSE™, which also are registered or are the subject of pending registration applications in the United States. We have the right to sell an exclusive line of Jaclyn Smith ® products through July 2014 (with an option to extend for an additional three-year term, subject to certain conditions). We also have the right to sell an exclusive line of Joe Boxer ® products through December 2015 (with an option to extend for up to two additional five-year terms, subject to certain conditions). Generally, our right to use our trade names and marks continues so long as we use them.
Seasonality
The retail business is seasonal in nature, and we generate a high proportion of our revenues, operating income and operating cash flows during the fourth quarter of our year, which includes the holiday season. As a result, our overall profitability is heavily impacted by our fourth quarter operating results. Additionally, in preparation for the fourth quarter holiday season, we significantly increase our merchandise inventory levels, which are financed from operating cash flows, credit terms received from vendors and borrowings under our amended credit agreement (described in the “Uses and Sources of Liquidity” section below). Fourth quarter reported revenues accounted for 30% of total reported revenues in each of the years 2011, 2010 and 2009. See Note 19 of Notes to Consolidated Financial Statements for further information on revenues earned by quarter in 2011 and 2010.
Competition
Our business is subject to highly competitive conditions. We compete with a wide variety of retailers, including other department stores, discounters, home improvement stores, consumer electronics dealers, auto service providers, specialty retailers, wholesale clubs, as well as many other retailers operating on a national, regional or local level. Online and catalog businesses, which handle similar lines of merchandise, also compete with us. Walmart, Target, Kohl’s, J.C. Penney, Macy’s, The Home Depot, Lowe’s, Best Buy and Amazon are some of the national retailers and businesses with which we compete. The Home Depot and Lowe’s are major competitors in relation to our home appliance business, which accounted for approximately 16% of our 2011 and 2010 and 15% of our 2009 reported revenues. Sears Canada competes in Canada with Hudson’s Bay Company, other Canadian-based store and online retailers, as well as certain U.S.-based competitors, including those mentioned above, that may be expanding into Canada. Success in these competitive marketplaces is based on factors such as price, product assortment and quality, service and convenience, including availability of retail-related services such as access to credit, product delivery, repair and installation. Additionally, we are influenced by a number of factors including, but not limited to, the cost of goods, consumer debt availability and buying patterns, economic conditions, customer preferences, inflation, currency exchange fluctuations, weather patterns, and catastrophic events. Item 1A in this report on Form 10-K contains further information regarding risks to our business.
Employees
At January 28, 2012, subsidiaries of Holdings had approximately 264,000 employees in the United States and U.S. territories, and approximately 29,000 employees in Canada through Sears Canada. These employee counts include part-time employees.
Our Website; Availability of SEC Reports and Other Information
Our corporate website is located at searsholdings.com. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to these reports are available, free of charge, through the “SEC Filings” portion of the Investor Information section of our website as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”).
The Corporate Governance Guidelines of our Board of Directors, the charters of the Audit, Compensation, Finance and Nominating and Corporate Governance Committees of the Board of Directors, our Code of Conduct and the Board of Directors Code of Conduct are available in the Corporate Governance section of searsholdings.com. References to our website address do not constitute incorporation by reference of the information contained on the website, and the information contained on the website is not part of this document.
Item 1A. Risk Factors
Our operations and financial results are subject to various risks and uncertainties, including those described below, which could adversely affect our business, results of operations and financial condition.
If we fail to offer merchandise and services that our customers want, our sales may be limited, which would reduce our revenues and profits.
In order for our business to be successful, we must identify, obtain supplies of, and offer to our customers, attractive, innovative and high-quality merchandise on a continuous basis. Our products and services must satisfy the desires of our customers, whose preferences may change in the future. If we misjudge either the demand for products and services we sell or our customers’ purchasing habits and tastes, we may be faced with excess inventories of some products and missed opportunities for products and services we chose not to offer. In addition, our sales may decline or we may be required to sell the merchandise we have obtained at lower prices. This would have a negative effect on our business and results of operations.
Our integrated retail strategy is based on a number of initiatives, including our Shop Your Way Rewards program, that depend on our ability to respond quickly to ongoing technology developments and implement new ways to understand and rely on the data to interact with our members and customers in order to achieve expected benefits.
If we do not successfully manage our inventory levels, our operating results will be adversely affected.
We must maintain sufficient inventory levels to operate our business successfully. However, we also must guard against accumulating excess inventory as we seek to minimize out-of-stock levels across all product categories and to maintain in-stock levels. We obtain a significant portion of our inventory from vendors located outside the United States. Some of these vendors often require lengthy advance notice of our requirements in order to be able to supply products in the quantities we request. This usually requires us to order merchandise, and enter into purchase order contracts for the purchase and manufacture of such merchandise, well in advance of the time these products will be offered for sale. As a result, we may experience difficulty in responding to a changing retail environment, which makes us vulnerable to changes in price. If we do not accurately anticipate the future demand for a particular product or the time it will take to obtain new inventory, our inventory levels will not be appropriate and our results of operations may be negatively impacted.
If we are unable to compete effectively in the highly competitive retail industry, our business and results of operations could be materially adversely affected.
The retail industry is highly competitive with few barriers to entry. We compete with a wide variety of retailers, including other department stores, discounters, home improvement stores, appliances and consumer electronics retailers, auto service providers, specialty retailers, wholesale clubs and many other competitors operating on a national, regional or local level. Some of our competitors are actively engaged in new store expansion. Online and catalog businesses, which handle similar lines of merchandise, and some of which are not required to collect sales taxes on purchases made by their customers, also compete with us. In this competitive marketplace, success is based on factors such as price, product assortment and quality, service and convenience.
Our success depends on our ability to differentiate ourselves from our competitors with respect to shopping convenience, a quality assortment of available merchandise and superior customer service. We must also successfully respond to our customers’ changing tastes. The performance of our competitors, as well as changes in their pricing policies, marketing activities, new store openings and other business strategies, could have a material adverse effect on our business, financial condition and results of operations.
Our business has been and will continue to be affected by worldwide economic conditions; a failure of the economy to sustain its recovery, a renewed decline in consumer-spending levels and other conditions, including inflation and changing prices of energy, could lead to reduced revenues and gross margins, and negatively impact our liquidity.
Many economic and other factors are outside of our control, including consumer and commercial credit availability, consumer confidence and spending levels, inflation, employment levels, housing sales and remodels, consumer debt levels, fuel costs and other challenges currently affecting the global economy, the full impact of which on our business, results of operations and financial condition cannot be predicted with certainty. These economic conditions adversely affect the disposable income levels of, and the credit available to, our customers, which could lead to reduced demand for our merchandise. Changing fuel and energy costs may have a significant impact on our operations. We require significant quantities of fuel for the vehicles used by technicians in our home services business and we are exposed to the risk associated with variations in the market price for petroleum products. We could experience a disruption in energy supplies, including our supply of gasoline, as a result of factors that are beyond our control, which could have an adverse effect on our business. Certain of our vendors also are experiencing increases in the cost of various raw materials, such as cotton, oil-related materials, steel and rubber, which could result in increases in the prices that we pay for merchandise, particularly apparel appliances and tires. The domestic and international political situation also affects consumer confidence. The threat, outbreak or escalation of terrorism, military conflicts or other hostilities could lead to a decrease in consumer spending. Any of these events and factors could cause us to increase inventory markdowns and promotional expenses, thereby reducing our gross margins and operating results.
The lack of willingness of our vendors to provide acceptable payment terms could negatively impact our liquidity and/or reduce the availability of products or services we seek to procure.
We depend on our vendors to provide us with financing on our purchases of inventory and services. Our vendors could seek to limit the availability of vendor credit to us or other terms under which they sell to us, or both, which could negatively impact our liquidity. In addition, the inability of vendors to access liquidity, or the insolvency of vendors, could lead to their failure to deliver inventory or other services. Certain of our vendors finance their operations and/or reduce the risk associated with collecting accounts receivable from us by selling or “factoring” the receivables or by purchasing credit insurance or other forms of protection from loss associated with our credit risks. The ability of our vendors to do so is subject to the perceived credit quality of the Company. Such vendors could be limited in their ability to factor receivables or obtain credit protection in the future because of our perceived financial position and creditworthiness, which could reduce the availability of products or services we seek to procure.
Certain factors, including changes in our credit ratings, may limit our access to capital markets and other financing sources and materially increase our borrowing costs.
In addition to credit terms from vendors, our liquidity needs are funded by our operating cash flows and, to the extent necessary, borrowings under our credit agreements and commercial paper program and access to capital markets. The availability of financing depends on numerous factors, including economic and market conditions, our operating performance, our credit ratings, and lenders’ assessments of our prospects and the prospects of the retail industry in general. Changes in these factors may affect our cost of financing, liquidity and our ability to access financing sources, including the accordion feature of our domestic revolving credit facility and possible second lien indebtedness that is permitted under the domestic revolving credit facility. In 2011, our credit ratings were downgraded by the three primary nationally recognized statistical rating organizations. Rating agencies revise their ratings for the companies that they follow from time to time and our ratings may be revised or withdrawn in their entirety at any time.
The lenders under our credit facilities may not be able to meet their commitments if they experience shortages of capital and liquidity and there can be no assurance that our ability to otherwise access the credit markets will not be adversely affected by changes in the financial markets and the global economy.
Due to the seasonality of our business, our annual operating results would be adversely affected if our business performs poorly in the fourth quarter.
Our business is seasonal, with a high proportion of revenues, operating income and operating cash flows being generated during the fourth quarter of our year, which includes the holiday season. As a result, our fourth quarter operating results significantly impact our annual operating results. Our fourth quarter operating results may fluctuate significantly, based on many factors, including holiday spending patterns and weather conditions.
CEO BACKGROUND
Louis J. D’Ambrosio , 47, joined the Company as our Chief Executive Officer and President in February 2011. He served as the President and Chief Executive Officer of Avaya Inc. from July 2006 to June 2008. He also served as a director of Avaya from November 2006 to June 2008. Mr. D’Ambrosio was previously Avaya’s Senior Vice President and President, Global Sales and Marketing from November 2005 until July 2006. From January 2004 until November 2005, Mr. D’Ambrosio served as Avaya’s Group Vice President, Global Sales, Channels and Marketing. From December 2002 until December 2003, Mr. D’Ambrosio was Avaya’s Group Vice President, Avaya Global Services. Before joining Avaya, Mr. D’Ambrosio spent 16 years at International Business Machines Corporation, where he held several executive posts and was a member of the worldwide management committee. His roles included leading strategy for global services, sales and marketing for software, and industry operations for Asia Pacific. Mr. D’Ambrosio currently serves as the Non-Executive Chairman of the Board of Directors of Sensus (Bermuda 2) Ltd. and Sensus USA Inc., a clean technology company. Mr. D’Ambrosio brings valuable experience in leading and transforming a Fortune 500 company, technology insights, overall business acumen and a proven track record in delivering strong returns to stockholders. Mr. D’Ambrosio was elected to the Board of Directors effective February 24, 2011.
William C. Kunkler , III , 55, is the Executive Vice President-Operations of CC Industries, Inc., an affiliate of Henry Crown and Company, and has served in that position, as well as other officer positions, since 1994. CC Industries, Inc. is a private equity firm focused on manufacturing companies and real estate investments. Mr. Kunkler has extensive manufacturing company experience and a thorough understanding of business operations, including finance and accounting principles and functions as well as operational methodologies garnered from his experience as an executive officer and director of various companies. He also has strong ties to the Chicago area, the location of Sears Holdings Corporation’s corporate headquarters. Mr. Kunkler has served as a director of the Company since 2009.
Edward S. Lampert , 49, Chairman of our Board of Directors, is the Chairman and Chief Executive Officer of ESL Investments, Inc., which he founded in April 1988. Mr. Lampert has extensive experience in business and finance, and he has invested in many retail companies. He also served as Chairman of the Board of Kmart Holding Corporation, a company that emerged from bankruptcy in 2003 and was transformed into a profitable business prior to its merger with Sears, Roebuck and Co. in 2005.
Steven T. Mnuchin , 49, has served as Chairman and Chief Executive Officer of One West Bank Group LLC, the holding company of OneWest Bank, since January 2009. Mr. Mnuchin is also Chairman and Chief Executive Officer of Dune Capital Management LP, a private investment firm, and he has served in that or a similar capacity since September 2004. Mr. Mnuchin is a trustee of The Museum of Contemporary Art, Los Angeles, LAPD Foundation and New York Presbyterian Hospital. Mr. Mnuchin brings extensive experience in investment strategy and finance to the Sears Holdings Board through his positions at a financial institution and a private investment firm. He also gained extensive information technology experience during his tenure as the Chief Information Officer of Goldman, Sachs & Co. He served as a director of Kmart Holding Corporation, a company that emerged from bankruptcy in 2003 and was transformed into a profitable business prior to its merger with Sears, Roebuck and Co. in 2005.
Ann N. Reese , 59, co-founded the Center for Adoption Policy in New York in 2001 and serves as its Executive Director. Prior to co-founding the Center, Ms. Reese served as a Principal with Clayton, Dubilier & Rice, a private equity investment firm, in 1999 and 2000. From 1995 to 1998, she was Executive Vice President and Chief Financial Officer of ITT Corp., a hotel and gaming company. Ms. Reese is a director of Xerox Corporation and Genesee & Wyoming Inc. Ms. Reese served as a director of Merrill Lynch & Co., Inc. from July 2004 until its acquisition by Bank of America Corporation in January 2009. Ms. Reese also served as director of CBS Corporation from November 2005 to October 2006, and of The Jones Group Inc. from July 2003 to May 2011. Ms. Reese has extensive executive experience in corporate finance, financial reporting and strategic planning through her position as a public company chief financial officer as well as corporate governance expertise gained from her experience on other public company boards. Ms. Reese also served as a director of Kmart Holding Corporation, a company that emerged from bankruptcy in 2003 and was transformed into a profitable business prior to its merger with Sears, Roebuck and Co. in 2005.
Emily Scott , 50, is a founding partner and director of Plum TV, LLC, a television station network operating in select resort markets. Ms. Scott served as a director until December 2006, Chairman of the Board of Directors of J. Crew from 1997 to 2003 and had previously served as Vice Chairman and other roles since the company founding in 1983. Ms. Scott has extensive retail and apparel experience through her position at a retail company. Ms. Scott has served as a director of the Company since 2007.
Thomas J. Tisch , 57, has served as the Managing Partner of Four Partners, a private investment firm, since 1992. He has served as the Chancellor of Brown University since July 2007, and he is also a trustee of New York University Medical Center. Mr. Tisch brings financial and general business expertise to the Sears Holdings Board from his position at a private investment firm. Mr. Tisch also served as a director of Kmart Holding Corporation, a company that emerged from bankruptcy in 2003 and was transformed into a profitable business prior to its merger with Sears, Roebuck and Co. in 2005.
The Nominating and Corporate Governance Committee of our Board of Directors is responsible for reviewing the qualifications and independence of members of the Board and its various committees on a periodic basis, as well as the composition of the Board as a whole. This assessment includes members’ qualification as independent and their economic interest in the Company through meaningful share ownership, as well as consideration of diversity, age, skills and experience in relation to the needs of the Board. Director nominees will be recommended to the Board by the Nominating and Corporate Governance Committee in accordance with the policies and principles in its charter. The ultimate responsibility for selection of director nominees resides with the Board of Directors.
While the Company does not have a formal diversity policy, as mentioned above, the Board considers diversity in identifying director nominees. The Board and the Nominating and Governance Committee believe that it is important that our directors represent diverse viewpoints. In addition to diversity of experience, the Nominating and Corporate Governance Committee seeks director candidates with a broad diversity of professions, skills and backgrounds. The Nominating and Corporate Governance Committee discusses the diversity of the Board annually.
The Board met 10 times during fiscal year 2011 (the fiscal year ended January 28, 2012). A majority of the directors attended 100% of the Board meetings and the meetings of the committees on which they served, and all directors attended at least 75% of such Board meetings and committee meetings. Our Corporate Governance Guidelines provide that directors are expected to attend the annual meeting of stockholders. All directors who stood for election at the 2011 annual meeting attended the 2011 annual meeting.
MANAGEMENT DISCUSSION FROM LATEST 10K
OVERVIEW OF HOLDINGS
Holdings is the parent company of Kmart and Sears. We are a broadline retailer and, at the end of 2011, had 2,172 Kmart and domestic full-line stores and 1,338 specialty retail stores in the United States operating through Kmart and Sears and 500 full-line and specialty retail stores in Canada operating through Sears Canada, a 95%-owned subsidiary. We plan to close 173 stores and change the format of 8 stores in the first half of 2012.
We currently conduct our operations in three reportable business segments: Kmart, Sears Domestic and Sears Canada. The nature of operations conducted within each of these segments is discussed within the “Business Segments” section of Item 1 in this report on Form 10-K. Our business segments have been determined in accordance with accounting standards regarding the determination, and reporting, of business segments.
The retail industry is highly competitive and as such, Holdings faces significant challenges, including the current macroeconomic environment, as many of our product categories are impacted by the housing market and availability of credit to our customers. The retail industry is also rapidly evolving as retail is increasingly impacted by new technologies and social media. We believe that this evolution provides us with significant growth opportunities, if we are able to transform our portfolio of businesses by leveraging our existing store network with emerging technologies and our Shop Your Way Rewards program to develop lasting relationships with our customers.
We consider ourselves to be an asset-rich enterprise with multiple resources at our disposal. At year end, we had $3.2 billion in liquidity and significant value in our asset portfolio, including valuable iconic proprietary brands, a valuable real estate portfolio, well- known stand-alone businesses and a flexible financial structure. We are taking actions to address our operating performance in three areas:
•
First, we are implementing immediate actions which we believe will improve our financial performance, including cost and inventory reductions, closure of marginally performing stores, actions to improve margins, and bringing in talent to strengthen the leadership team. We have reduced inventory by $544 million below last year’s level and our promotional cadence has been adjusted to be more targeted.
•
Second, we are executing actions intended to unlock the value of our portfolio, such as our recently announced real estate transactions that are expected to generate approximately $440 million ($270 million for Sears Domestic and $170 million Canadian for Sears Canada) in cash proceeds upon their closing, which are expected to occur in our first quarter, as well as our announcement of plans to separate the Hometown and Outlet businesses and certain hardware stores through a transfer to electing shareholders to purchase an interest in these businesses. The Hometown and Outlet businesses and certain hardware stores combined assets represent approximately $2.3 billion to $2.6 billion in SHC revenue and between $70 million and $80 million in SHC EBITDA with $350 million to $400 million in SHC net assets and $325 million to $375 million in SHC net inventory (net of merchandise payables).
•
Third, we are accelerating actions intended to drive our strategic agenda to become the leader in Integrated Retail. Profound changes in technology are changing the entire retail landscape, the ways customers shop and the way they live. Americans spend as much time today on the internet as they do watching TV, and more time today on their mobile devices than they do with print media. Customers are more connected and empowered than ever before. We are accelerating our actions to bring together a unique set of technology and retail assets to deliver a seamless, integrated experience for our Shop Your Way Rewards members and customers—at the store, online, and in the home. At the core of our strategy we are building a deeply engaging membership program, called Shop Your Way Rewards . We’re building technologies and a platform that we expect will allow us to have continuous relationships with our customers.
•
We launched our Shop Your Way Rewards program late in 2009 and continued to grow membership and capabilities in 2011. The Shop Your Way Rewards program is intended to transition Sears Holdings from serving customers to building relationships with members. We believe that Shop Your Way Rewards will allow us to learn more about our individual customers and therefore position us to better meet their needs. The Shop Your Way Rewards program will also enhance our ability to communicate with customers digitally. Such digital communication tools present a new opportunity to personalize our messages and make them more individually relevant. What the future holds for Sears Holdings is a progressive re-shaping and deepening of our relationships with our members. Given the size of our membership today and the breadth of our assortment, this is very compelling for our business model.
•
In 2011, we invested several hundred million dollars in our customer experience across touch points. We believe that our investments will deliver compelling benefits to our members, several of which are already in the market, like return and exchanges of online purchases in 5 minutes or less; no receipt required; great deals personalized to consumers’ interests; and assistance by associates with innovative technology applications and devices to help find the right appliance or TV or tractor to fit our customers’ needs.
•
We will continue to invest in our online properties. By integrating our vast store network with our online properties, we believe that Sears Holdings will succeed in the rapidly evolving retail environment. The web and mobile platforms integrate shopping and marketing in a very different way than stores and traditional media have in the past.
Gain on Sales of Assets
We recorded a gain on the sales of assets of $64 million during 2011 and $67 million in 2010. Gain on sales of assets for 2011 included a gain of $21 million recognized on the sale of two stores in California operated under The Great Indoors format and $12 million recognized on the sale of a store in Indiana operated under the Kmart format. Gain on sales of assets for 2010 was impacted by the recognition of a previously deferred gain on the sale of assets. We sold a Sears Auto Center in October 2006, at which time we leased back the property for a period of time. Given the terms of the contract, for accounting purposes, the excess of proceeds received over the carrying value of the associated property was deferred. We closed our operations at this location during the first quarter of 2010 and, as a result, recognized a gain of $35 million on this sale at that time.
Operating Income (Loss)
We recorded an operating loss of $1.5 billion in 2011, as compared to operating income of $437 million in 2010. Operating loss for 2011 included a $551 million non-cash impairment charge related to goodwill balances of certain reporting units, expenses related to domestic pension plans, store closings, severance and hurricane losses, and a net gain on sales of assets, which aggregated to $964 million. Operating income for 2010 included expenses related to domestic pension plans, store closings and severance and a gain on sale of assets, which aggregated to $121 million. The decline in operating income of $1.9 billion was primarily the result of a decline in our gross margin dollars, given lower overall sales, and a decline in our gross margin rate of 180 basis points and an increase in the above noted charges.
Other Loss
Other loss is primarily comprised of mark-to-market and settlement gains and losses on Sears Canada hedge transactions. Total net mark-to-market and settlement losses of $1 million and $15 million were recorded on these transactions in 2011 and 2010, respectively. See Notes 4 and 5 of Notes to Consolidated Financial Statements for further information regarding these transactions.
Income Taxes
Our income tax expense effective tax rate for the year was 78.2% in 2011 and 16.3% in 2010. The increase in our tax rate was primarily due to several significant tax matters, which included a non-cash charge of $1.8 billion to establish a valuation allowance against certain deferred income tax assets and the nondeductible nature of our goodwill impairment.
2010 Compared to 2009
Net Income from Continuing Operations Attributable to Holdings’ Shareholders
We recorded net income from continuing operations attributable to Holdings’ shareholders of $122 million and $218 million ($1.09 and $1.85 per diluted share from continuing operations) for 2010 and 2009, respectively. Our results for 2010 and 2009 were affected by a number of significant items. Our net income from continuing operations, as adjusted for these significant items was $220 million ($1.97 per diluted share from continuing operations) for 2010 and $359 million ($3.05 per diluted share from continuing operations) for 2009. The decrease in net income for the year reflects a decrease in operating income of $230 million, primarily due to a decline in gross margin, due to lower overall revenues, partially offset by a decline in selling and administrative expenses.
Revenues and Comparable Store Sales
Revenues declined $696 million, or 1.6%, to $42.7 billion, in 2010 from $43.4 billion in 2009. The decrease was primarily due to lower comparable store sales and the impact of having fewer Kmart and Sears Full-line stores in operation during 2010. Revenues included a $433 million increase due to foreign currency exchange rates.
Domestic comparable store sales declined 1.3% in the aggregate, with an increase at Kmart of 0.8% and a decline at Sears Domestic of 3.1% in 2010. The Kmart improvement was driven by increases in most categories, with higher increases in the apparel, footwear, jewelry, sporting goods and toys categories, partially offset by declines in the food and consumables and pharmacy categories. Declines in sales at Sears Domestic were primarily driven by the hardlines categories, as well as apparel. Over half of the total decline occurred in the consumer electronics category. In contrast, Sears’ footwear, jewelry and automotive categories generated comparable store sales growth during the period.
Gross Margin
We generated $11.7 billion in gross margin in 2010 and $12.0 billion in 2009. Gross margin dollars in 2010 included an increase of $142 million related to the impact of foreign currency exchange rates and charges of $12 million for markdowns recorded in connection with store closings announced during 2010. Gross margin for 2009 included a $37 million charge for markdowns recorded in connection with store closings. Gross margin declined $322 million as compared to the prior year, primarily due to declines in sales and margin rate at Sears Domestic and Sears Canada, partially offset by an increase in gross margin and margin rate at Kmart.
Sears Domestic’s gross margin rate decreased 90 basis points mainly due to reduced margin rates in home services and appliances. Sears Canada’s margin rate declined 180 basis points due to price compression in the appliance and electronics categories, as well as an increase in promotional and clearance markdowns related to a challenging economic environment. These declines were partially offset by an increase in margin rate of 110 basis points at Kmart, in part as a result of an increase in sales of higher margin categories such as apparel and sporting goods.
Selling and Administrative Expenses
Our selling and administrative expenses decreased $74 million in 2010 to $10.4 billion and included incremental expenses of $123 million related to our continued investment in our multi-channel capabilities and launch of our Shop Your Way Rewards program and an increase of $97 million related to the impact of foreign currency exchange rates. The decrease includes a $86 million reduction in payroll and benefits expense, a $33 million reduction in advertising expense and a $40 million reduction in insurance expense, as well as reductions in various other expense categories. Selling and administrative expenses for 2010 were impacted by domestic pension plan expense of $120 million and store closing costs and severance of $14 million. Selling and administrative expenses for 2009 were impacted by domestic pension plan expense of $170 million and store closing costs and severance of $82 million, partially offset by a gain of $32 million recorded in connection with the settlement of Visa/MasterCard antitrust litigation.
Our selling and administrative expense rates were 24.4% for 2010 and 24.2% for 2009. The increase in our selling and administrative expense rate is primarily the result of lower expense leverage given lower overall sales.
Depreciation and Amortization
Depreciation and amortization expense decreased by $25 million during 2010 to $869 million and included charges of $10 million and $12 million in 2010 and 2009, respectively, taken in connection with store closings. The decrease is primarily attributable to having fewer assets available for depreciation.
Gain on Sales of Assets
We recorded a gain on the sales of assets of $67 million during 2010 and $74 million in 2009. Gain on sales of assets for 2010 and 2009 were impacted by the recognition of previously deferred gains on sales of assets.
We sold a Sears Auto Center in October 2006, at which time we leased back the property for a period of time. Given the terms of the contract, for accounting purposes, the excess of proceeds received over the carrying value of the associated property was deferred. We closed our operations at this location during the first quarter of 2010 and, as a result, recognized a gain of $35 million on this sale at that time.
Sears Canada sold its headquarters office building and adjacent land in Toronto, Ontario in August 2007. Sears Canada leased back the property under a leaseback agreement through March 2009, at which time it finished its relocation of all head office operations to previously underutilized space in the Toronto Eaton Centre, Ontario. Given the terms of the leaseback, for accounting purposes, the excess of proceeds received over the carrying value of the associated property was deferred, and the resulting $44 million gain was recognized when Sears Canada no longer occupied the associated property in 2009.
Operating Income
Operating income was $437 million for 2010 and $667 million for 2009. Operating income decreased $230 million and was the result of reductions in gross margin, partially offset by lower selling and administrative expenses. Operating income for 2010 included expenses of $156 million related to domestic pension plans, store closings and severance and a $35 million gain recognized on the sale of a Sears Auto Center. Operating income for 2009 included expenses of $301 million related to domestic pension plans, store closings and severance, a $44 million gain recognized by Sears Canada on the sale of its former headquarters, and a $32 million gain recorded in connection with the settlement of Visa/MasterCard antitrust litigation.
Interest Expense
We incurred $293 million in interest expense during 2010 and $248 million in 2009. Our interest expense increased primarily due to an increase in average total debt balances throughout 2010.
Other Loss
Other loss is primarily comprised of mark-to-market and settlement gains and losses on Sears Canada hedge transactions. Total net mark-to-market and settlement losses of $15 million were recorded on these transactions in 2010. Total net mark-to-market and settlement losses of $67 million were recorded on these transactions in 2009. See Notes 4 and 5 of Notes to Consolidated Financial Statements for further information regarding these transactions.
Income Taxes
Our effective tax rate was 16.3% in 2010 and 28.4% in 2009. The decrease in our tax rate is primarily due to lower taxable income and the resolution of certain federal and state income tax matters during 2010, which resulted in a $13 million tax benefit.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
OVERVIEW OF HOLDINGS
Holdings, the parent company of Kmart and Sears, was formed in connection with the March 24, 2005 Merger of these two companies. We are a broadline retailer with 2,075 full-line and 1,282 specialty retail stores in the United States, operating through Kmart and Sears, and 491 full-line and specialty retail stores in Canada operating through Sears Canada Inc. (“Sears Canada”), a 96%-owned subsidiary. We conduct our operations in three business segments: Kmart, Sears Domestic and Sears Canada. The nature of operations conducted within each of these segments is discussed within the “Business Segments” section of Part I, Item 1 of our Annual Report on Form 10-K for the year ended January 28, 2012 .
On December 30, 2011, we completed the spin-off to our shareholders of all the capital stock of Orchard Supply Hardware Stores Corporation (“Orchard”) that was owned by Holdings immediately prior to the spin-off. Holdings has no significant continuing involvement in the operations of Orchard. Accordingly, the results for Orchard are presented as discontinued operations in the Consolidated Results of Operations.
Gross Margin
For the quarter, our gross margin decreased $70 million to $2.5 billion in 2012. The decrease was primarily driven by declines in Sears Canada. Sears Canada’s gross margin decreased due to the decline in overall sales, as well as margin rate and included a decrease of $16 million related to the impact of foreign currency exchange rates. Gross margin at Kmart declined despite the increase in margin rate. Sears Domestic gross margin improved as margin rate increases more than offset the decline in overall sales. Gross margin for 2011 included charges of $22 million related to store closures.
Sears Canada’s gross margin rate declined 180 basis points for the second quarter primarily as a result of rate declines in electronics, jewelry, accessories and luggage, fitness and recreation. Kmart and Sears Domestic’s gross margin rates improved 60 basis points and 210 basis points, respectively, during the second quarter mainly due to lower clearance activity in the apparel business. Kmart and Sears Domestic also benefited from improved margins in the toys and home appliances categories, respectively.
Selling and Administrative Expenses
Domestic selling and administrative expenses decreased $123 million in the second quarter of 2012 compared to the second quarter of 2011 predominately due to decreases in payroll and advertising expenses, which were partially offset by higher pension expense. Selling and administrative expenses included expenses related to domestic pension plans, store closings and severance of $59 million and $36 million for 2012 and 2011, respectively. Selling and administrative expenses at Sears Canada for the quarter decreased $41 million from last year, and included a decrease of $15 million related to the impact of foreign currency exchange rates. On a Canadian dollar basis, selling and administrative expenses decreased by $26 million, primarily due to decreases in advertising and payroll expenses.
Our selling and administrative expenses as a percentage of total revenues (“selling and administrative expense rate”) was 25.7% for the second quarter of 2012, consistent with the prior year, as the decreases in overall selling and administrative expenses were offset by the above noted decline in revenues.
Gain on Sales of Assets
We recorded total gains on sales of assets for the quarter of $15 million in 2012 and $29 million in 2011. The gains recorded during the second quarter of 2011 included a gain of $21 million recognized on the sale of two stores in California operated under The Great Indoors format.
Operating Loss
For the second quarter, we reported an operating loss of $103 million and $191 million in 2012 and 2011, respectively. Operating loss for the second quarter included expenses related to domestic pension plans, store closings and severance, which aggregated to an operating loss of $66 million in 2012 and 2011. Operating loss for the second quarter of 2011 also included a gain on sales of assets of $21 million. The improvement in operating loss of $88 million was due to the reduction in selling and administrative expenses and an improvement in gross margin rate, which was partially offset by a decline in gross margin dollars driven by lower overall sales.
Interest Expense
We incurred $65 million and $71 million in interest expense during the second quarter of 2012 and 2011, respectively. The decrease is due to lower average outstanding borrowings.
Other Income
Other income is primarily comprised of mark-to-market and settlement gains and losses on Sears Canada hedge transactions (see Notes 3 and 4 to the Condensed Consolidated Financial Statements for further information regarding these transactions). Total net settlement gains of $1 million were recorded on these transactions in the second quarter of 2012, while total net mark-to-market and settlement gains of $5 million were recorded on these transactions in the second quarter of 2011.
Income Tax Benefit
Our effective tax rate for the second quarter was a benefit of 15.8% and 39.3% in 2012 and 2011, respectively. The current year tax rate was impacted by the establishment of a valuation allowance in 2011 against certain deferred income tax assets and the utilization of part of our net operating loss deferred tax asset in 2012.
26-week period ended July 28, 2012 compared to the 26-week period ended July 30, 2011
Revenues and Comparable Store Sales
For the first half of 2012, revenues decreased $941 million to $18.7 billion, as compared to revenues of $19.7 billion for the first half of 2011. The decline in revenue was primarily due to lower domestic comparable store sales for the first half of the year as well as the effect of having fewer Kmart and Sears Full-line stores in operation and a decline in Sears Canada’s comparable store sales. First half 2012 revenues included a decrease of $75 million due to changes in foreign currency exchange rates.
Domestic comparable store sales declined 2.8%, comprised of declines of 2.5% at Sears Domestic and 3.2% at Kmart. While Sears Domestic experienced an overall decrease in comparable store sales, it did achieve increases in its apparel, home and footwear categories. These increases were more than offset by declines in the consumer electronics, home appliances and lawn and garden categories as well as declines at Sears Auto Centers. Kmart’s comparable store sales decline reflects decreases in a majority of its categories, most notably the consumer electronics, pharmacy, and grocery and household categories, partially offset by increases in the apparel and footwear categories. Sears Canada’s comparable store sales decreased 6.7% for the first half of 2012 primarily due to sales decreases in women’s apparel, tools and lawn and garden, home décor and men’s apparel, partially offset by improved performance in home appliances and mattresses.
Gross Margin
For the first half of the year, our gross margin decreased $47 million to $5.1 billion in 2012. The decrease was driven by improvements in margin rate, offset by the decline in overall sales and included a decrease of $22 million related to the impact of foreign currency exchange rates on gross margin at Sears Canada. Gross margin for the first half of 2011 included charges of $23 million related to store closures.
Kmart’s gross margin rate improved 60 basis points for the first half mainly due to the margin rate improvement in the toys and apparel categories driven by less markdown activity. Sears Domestic’s gross margin rate improved 170 basis points for the first half primarily due to improved margins in the home appliances, apparel and footwear categories. Sales generated in the closing stores contributed to the improved margins. Sears Canada’s gross margin rate decreased 70 basis points for the first half mainly due to rate declines in electronics, children’s wear, jewelry, accessories and luggage and footwear.
Selling and Administrative Expenses
Domestic selling and administrative expenses decreased $160 million in the first half of 2012 compared to the first half of 2011 predominately due to decreases in payroll and advertising expenses. Selling and administrative expenses included expenses related to domestic pension plans, store closings and severance of $134 million and $56 million for 2012 and 2011, respectively. Selling and administrative expenses at Sears Canada for the first half decreased $66 million from last year, and included a decrease of $22 million related to the impact of foreign currency exchange rates. On a Canadian dollar basis, selling and administrative expenses decreased by $44 million, primarily due to a decrease in advertising expense.
Our selling and administrative rate was 26.1% for the first half of 2012, as compared to 26.0% for the first half of 2011, as reductions in expenses were offset by the above noted decline in revenues.
Gain on Sales of Assets
We recorded total gains on sales of assets for the first half of $410 million in 2012 and $31 million in 2011. The gains recorded during the first half of 2012 included a gain of $223 million recognized on the sale of eleven (6 owned and 5 leased) Sears Full-line store locations to General Growth Properties for $270 million in cash proceeds, and a gain of $163 million recognized on the surrender and early termination of the leases on three properties operated by Sears Canada, under an agreement with The Cadillac Fairview Corporation Limited for which Sears Canada received $170 million Canadian in cash proceeds. In connection with these transactions, we surrendered substantially all of our rights and obligations under our preexisting lease agreements and agreed to surrender each of the premises in periods ranging from 6 to 23 months from the date of closing. The gains on sales of assets recorded during the first half of 2011 included a gain of $21 million recognized on the sale of two stores in California operated under The Great Indoors format.
Operating Income (Loss)
We reported operating income for the first half of $212 million in 2012 compared to an operating loss of $363 million in 2011. Operating income for the first half of 2012 included expenses related to domestic pension plans, store closings and severance, as well as gains on sales of assets, which aggregated to operating income of $245 million. Operating loss for the first half of 2011 included expenses of $87 million related to domestic pension plans, store closings and severance, as well as a gain on sales of assets of $21 million. Operating income for the first half of 2012 benefited primarily from the above noted real estate transactions as well as a decrease in selling and administrative expenses.
Interest Expense
We incurred $131 million and $146 million in interest expense during the first half of 2012 and 2011, respectively. The decrease is due to lower average outstanding borrowings.
Other Income (Loss)
Other income (loss) is primarily comprised of mark-to-market and settlement gains and losses on Sears Canada hedge transactions (see Notes 3 and 4 to the Condensed Consolidated Financial Statements for further information regarding these transactions). Total net settlement gains of $2 million were recorded on these transactions in the first half of 2012, while total net mark-to-market and settlement losses of $7 million were recorded on these transactions in the first half of 2011.
Income Tax Expense/Benefit
Our effective tax rate for the first half was an expense of 40.8% in 2012 and a benefit of 35.2% in 2011. The current year tax rate was impacted by the establishment of a valuation allowance in 2011 against certain deferred income tax assets and the utilization of part of our net operating loss deferred tax asset in 2012.
SEGMENT OPERATIONS
The following discussion of our business segment results is organized into three reportable segments: Kmart, Sears Domestic and Sears Canada.
Gross Margin
For the quarter, Kmart generated $788 million in gross margin in 2012 and $825 million in 2011. The decrease in Kmart’s gross margin is due to the decrease in sales, which more than offset the improvement in gross margin rate. Kmart’s gross margin rate for the quarter was 23.4% in 2012 and 22.8% in 2011. The improvement in rate was primarily due to lower clearance activity in the apparel business as well as improved margin in the toys category. Gross margin for 2011 included charges of $7 million related to store closures.
Selling and Administrative Expenses
For the quarter, Kmart’s selling and administrative expenses decreased $46 million as compared to the second quarter in 2011. The decrease primarily reflects decreases in payroll expenses and advertising. Selling and administrative expenses for the second quarter of 2012 and 2011 were impacted by expenses of $8 million and $3 million, respectively, related to store closings and severance.
Kmart’s selling and administrative expense rate for the quarter was 22.6% in 2012 and 22.3% in 2011 and increased primarily as a result of lower expense leverage due to the sales decline noted above.
Operating Loss
For the quarter, Kmart recorded an operating loss of $4 million in 2012 and an operating loss of $16 million in 2011. The reduction in Kmart’s operating loss was primarily the result of the above noted decrease in selling and administrative expenses, as well as the increase in gross margin rate, partially offset by the decline in sales.
26-week period ended July 28, 2012 compared to the 26-week period ended July 30, 2011
Revenues and Comparable Store Sales
For the first half of 2012, Kmart’s revenues decreased by $314 million, while comparable store sales decreased 3.2%. The decline in revenue was also due to the impact of Kmart having fewer stores in operation during the first half of 2012. The decrease in comparable store sales reflects decreases in a majority of its categories, most notably the consumer electronics, pharmacy, and grocery and household categories, which declined for the same reasons as noted above, partially offset by increases in the apparel and footwear categories.
Gross Margin
For the first half of the year, Kmart generated $1.6 billion in gross margin in 2012 and $1.7 billion in 2011. The decrease in Kmart’s gross margin is due to the decrease in sales, which more than offset the improvement in gross margin rate. Kmart’s gross margin rate for the first half was 24.1% in 2012 and 23.5% in 2011. The increase in Kmart’s gross margin rate is due to rate improvement in the toys and apparel categories driven by less markdown activity. Sales generated in the closing stores contributed to the improved margins. Gross margin for the first half of 2011 included charges of $7 million related to store closures.
CONF CALL
Bill Phelan - SVP, Finance
Thank you, operator. Good morning and welcome to Sears Holdings earnings call. I am Bill Phelan, the Senior Vice President of Finance for Sears Holdings. Joining me today are Louis D'Ambrosio, our Chief Executive Officer, Rob Schriesheim, our Chief Financial Officer and Ron Boire, our Chief Merchant and President of the Sears and Kmart Formats.
For our call today, you may follow along with the slides that are shown. Slides will be automatically advanced during the discussion and will be posted to our website after today's call. Before we begin, I would like to remind you that today's discussion will contain forward-looking statements related to future events and expectations.
These statements are based on current expectations and the current economic environment and actual results may differ materially from those expressed or implied in the forward-looking statements. You can find factors that could cause the company's actual results to differ materially listed in today's press release in the presentation for today's call that is posted at the Investor Information section of searsholdings.com and in our most recent SEC filings.
In addition our discussion will include certain non-GAAP financial measures. Reconciliation to the most directly comparable GAAP financial measures can be found in today’s press release. Any reference that our discussion to EBITDA means adjusted EBITDA as defined in the press release and presentation. Finally we assume no obligation to update the information presented on this call except as required by law. Now I would like to turn the call over to Louis.
Louis D'Ambrosio - CEO & President
Thanks Bill and thank you all for joining us today. I know we haven’t typically held earnings call, but we thought it was important to provide you more detail on a number of extraordinary items we are recording this quarter and importantly to make our funding strategy clear. The takeaway is that the company’s significant assets and liquidity as well as the actions we are taking which we will describe today make our result and earnings issue rather than an asset or liquidity one. Today we will discuss our financial performance, our funding strategy and specific actions we are taking to further strengthen the balance sheet and operations.
Additionally I will preview the strategic agenda for Sears Holdings which will guide our actions going forward. We will cover this in more detail at our annual meeting on May 2nd. So let us get right into it. Our fourth quarter earnings were unacceptable. We know that and are taking immediate actions to address it in three areas. First; actions to improve our financial performance including cost reductions, actions to improve inventory productivity, actions to improve margins, honed and targeted marketing and new talent to strengthen our merchandising and leadership team.
Second we are executing actions to unlock the value of our portfolio and assets. We will discuss two such actions today expected to generate approximately $700 million of proceeds and third we are accelerating actions to drive our strategic agenda to lead in integrated retail. So let us first talk about the quarter. Our main challenge in the quarter was margin rate. The largest margin decline was in apparel and related categories particularly Kmart apparel, Lands’ End and footwear.
Several factors contributed to the declines in these categories. We saw a significant increase in commodity costs particularly cotton. High inventory levels led to increased markdowns and clearance. And unseasonably warm weather impacted several categories such as Lands’ End’s typically strong outer wear business. These are explanations of what happened, but they are not excuses. There are actions we could have taken to have mitigated the margin decline. Our buy could have been executed better, both in terms of quantity and assortment. Our promotional cadence should have been more surgical and cost actions could have been taken earlier.
Actions of each of these areas are now well underway. We have reduced inventory by $544 million below last year’s levels. Our promotional design is been refined and targeted. We have implemented cost actions which we believe will yield in the higher end of the $100 to $200 million estimate we have previously provided. We recently announced the hiring of Ron Boire as the Chief Merchant and President of the Sears and Kmart formats to focus on merchandizing, cross category synergies and strengthening our formats around integrated retail.
Ron joins us from Brookstone where he was CEO. Ron joins other recent additions to the team with significant retail experience. Like Sam Solomon, who was CEO of Coleman and now leads our Tools business and Edgar Huber who was CEO of Juicy Couture and now leads Lands’ End.
While we are disappointed in our performance, it is important to distinguish the income statement performance from the balance sheet strength and flexibility, we are an asset rich enterprise with significant liquidity as Rob will describe in detail shortly.
We’re taking actions to unlock the value of our assets and portfolio. We announced today as an example that we plan to transfer direct ownership of Sears Hometown and Outlet businesses and certain hardware stores together as a separate company to our electing shareholders. We expect this transaction to generate $400 million to $500 million of proceeds. Additionally, we announced today a real-estate transaction which we expect to generate proceeds of $270 million within the next 60 days.
We also have a Board with significant ownerships. Our Board owns 65% of the outstanding equity. Accordingly, as equity investors, the Board comes behind all creditors, secured and unsecured. We have a Board focused on creating real, long-term value. I also want to touch briefly on the situation with our trading factor as there has been a lot of press and speculation on this topic. We have had good discussions with our trade partners and factors. And we have presented them with the facts on our financial position. They have been very good, very constructive discussion. They know that when we succeed they succeed.
Now before I turn it over to Rob, I would like to take a few minutes to discuss the strategic framework for our company that will inform and guide our actions moving forward. As we accelerate the transformation of our company we do so with the point of view on how the industry and our world is changing. Rapid advances in technology are transforming the entire retail landscape and where customers work live and shop. Our media and shopping channel are blurring. We no longer choose between shopping online or shopping in the store. We do both and we do it differently at different times. Our customers are using mobile devices to find deals, look up reviews and poll friends even while standing in the aisle. We believe the retailers who best use technology to integrate the customer experience across all channels will be the ones who win. And we are accelerating our actions to bring together a unique set of technology and retail assets to deliver a seamless integrated and rewarding experience for our members and customers at the store, online and in the home.
In short to lead in integrated retail. And at the core of our integrated retail strategy we are building a deeply engaging membership program called SHOP YOUR WAY REWARDS. The program is enabled by technologies and a platform that we expect will allow us to have continuous relationships with our members and customers.
In 2011, we invested several hundred million dollars in our customer experience. We believe that our investments will deliver compelling benefits to our customers and members several of which are already in the market like pick-up, return and exchange of online purchases in five minutes or less. No receipt required, great deals personalized to your interests and online marketplace and being assisted by associates with mobile and iPad applications to help find the right appliance or TV or tractor to fit your need.
So then what the future holds for Sears Holdings is a progressive reshaping and deepening of our relationships with our members through integrated retail. And given the growing size of our membership and the breadth of our assortment this is very compelling for our business model.
As an example, at each of our Shop Your Way Rewards members visited just one more time in a year and purchased an average transaction, we would generate more than $1 billion of additional margin and our assets play particularly well to this strategy. We have an extensive set of customer touch points to further fuel the membership and engagement.
As an example, over this past year, we have had over 1 billion visits to Sears and Kmart across our stores and online. Additionally, we are unique in being invited to our customers’ homes over 15 million times a year through our services business and have over 80 million interactions through our call centers.
Also our members through Shop Your Way Rewards have access to uniquely broad assortment. This assortment enables our members to satisfy many parts of their lives. We also own some of the most important brands in retail such as Kenmore, Craftsman, DieHard, Lands' End.
Kenmore, as an example is in the homes of 100 million American and in the most recent quarter, we gained market share in appliances in both units and dollars while increasing margin rate. And in addition to assortments across owned format members now have access to over 32 million products to our own line marketplace.
So as you can see by combining the technology platforms we are building, with our collection of retail assets, we believe we can deliver an extraordinary integrated customer experience. And in the coming months you’ll see our strategy play-out and innovations connecting our market leading brand, our unique retail assets and our broad range of touch points. We will discuss this in more detail on May 2nd at our Annual Meeting.
So we are prepared to take whatever steps are necessary from cost reductions and operational improvements to active portfolio management, to an acceleration of our strategic initiatives to restore our company to greatness and deliver attractive returns to our shareholders.
Now, let me turn it over to Rob to provide details about our financial. Rob?
Rob Schriesheim - EVP & CFO
Thanks Lou. Good morning and thank you for taking the time to join us on the call. Six months ago I joined as CFO, as I believe we have the opportunity to enhance and unlock value by better leveraging a unique portfolio of assets. My comments today which you can follow beginning on page six of the slide deck which will be automatically forwarded for you will cover the following.
First, our fourth quarter financial results providing detail on the accounting charges and significant items.
Second, structural actions already being executed on around cost reductions, store closures and inventory management.
Third, our financial capacity and funding strategy, which will outline our approach to the management of our capital structure.
Fourth and finally, actions underway to unlock value and our portfolio of assets.
Let me offer some contexts and broad themes that underlie our performance. First, two of our largest categories experienced industry wide declines and those two consumer electronics and appliances represented significant portion of our revenue decline.
Second, we experienced negative effects of an increase in commodity prices notably cotton and fuel coupled with too large of an apparel buy.
Third, unseasonably warm weather across the United States negatively impacted a number of our product categories including, seasonal apparel, snow blowers, snow tires and various other winter related categories. But, as Lou discussed, our execution should have been and needs to be better. We don’t consider these results to be acceptable nor are they indicative of the potential inherent in our portfolio of assets.
With that as background, I will now speak to some of the key elements of the quarter as shown on page eight. On a GAAP basis, we reported a net loss of $2.4 billion or $22.63 per share versus net income of $374 million or $3.43 per share last year. The current quarter includes $2.5 billion of accounting charges and significant items. It’s important to note that only about $95 million of this was cash and I’ll cover this in detail shortly.
On an adjusted basis, EPS from continuing operations for the quarter was $0.54 per share this year compared to $3.67 last year.
On a revenue basis, our consolidated revenues were down 4%. Domestically, we did however see growth of 2.6% in comp store sales since our December 27th announcement.
Overall, we were down 4.1% in comp store sales of Sears due to appliances and consumer electronics. Sears Apparel was up 2.9% across all three categories, including men’s, women’s and kids. This was the second consecutive quarter of growth due to the introduction of new products. We were down 2.7% at Kmart largely due to consumer electronics and lower lay-away. Sears Canada, which reported separately, had a 7.5% decline.
Since GAAP income includes many non-operating items, we use adjusted EBITDA to evaluate our performance. EBITDA declined by $568 million to $351 million this year.
Two quick points; Sears domestic was down $310 million primarily due to weakness in the consumer electronics business, marginal rate declines in seasonal apparel, Lands’ End and footwear and higher expenses in the quarter as we increased our holiday marketing expense. Last year also benefited from favorable adjustments from insurance reserve and property tax rebate. Kmart was down $217 million driven largely by apparel and consumer electronics.
Turning to the full year summary on page nine. On a GAAP basis, we reported a net loss of $3.1 billion or $29.40 per share versus net income of $133 million or $1.19 per share last year. The current year includes $2.7 billion of significant items and accounting adjustments and again I’ll review that shortly.
Adjusted for items, loss per share is $4.52 this year versus earnings per share of a $1.97 in 2010. Adjusted EBITDA for the year was $277 million versus $1.4 billion last year. Sears Domestic experienced a decline of $554 million and Kmart declined $336 million, primarily due to the same drivers of the fourth quarter such as consumers’ electronics and the effect of cost increases.
The quarter was affected by a number of significant items, the most significant of which are itemized on page 10 and the appendix on page 27. Let me speak to the three items which make up $2.4 billion of these charges.
First, we recorded a $1.7 billion non-cash charge to establish a valuation allowance against our domestic deferred tax assets. Accounting rules mandates that valuation reserve be established when income has not been generated over a three year cumulative period to support the deferred tax assets. While an accounting loss was recorded, no economic losses occurred as these NOLs and tax benefits remain available to reduce future taxes as income is generated in subsequent periods.
Second, we recorded a $551 million non-cash charge for the impairment of goodwill balances in our Sears full-line store, automotive and commercial sales format. The goodwill resulted from the Sears Kmart merger in 2005. Given the decline in profitability in these formats coupled with the recently announced store closures we recognized the impairment.
Third, during the quarter we had a $178 million charge for store closings and associated severance. This $178 million includes costs related to inventory markdowns, fixed asset impairments, severance, liquidator fees and lease costs for previously announced closures.
Based on experience with store closures, these closures typically are cash positive because we liquidate the inventory for more than its original cost and we have limited severance exposure as most store associates are part time. More details of the charges are available on page 27 in the appendix and after this call the presentation will be posted on our site.
On page 11, you can see that while the amount of these charges is significant for the three largest components, only $95 million affects cash. Also note that we recorded charge of approximately $75 million in future periods for lease obligations when the stores actually close.
Turning to page 12, as you know appliances is a very important business for us. We are able to increase our average selling price and margin rate in the quarter versus the prior year. However, overall category performance was significantly impacted by the adverse market conditions.
We estimate that industry shipments were down more than we were in the fourth quarter. While we did realize a sales increase in appliances in the quarter, we did pick up significant share on the strength of Kenmore.
Overall, appliance share improved by 220 basis points versus prior year. Our lead increased from 9.6 percentage points last year to 13.6 points this year and Kenmore picked up significant share as well. Kenmore increased share by 220 basis points to 17.8%. Kenmore is the market leader which is highly impressive when you consider that Kenmore is only available at Sears, it speaks to the power of our appliance franchise.
As you can see on page 13, we are taking a number of actions to improve our performance by reducing our cost structure and working capital balances as well as seeking to improve our margins. We are closing marginally performing stores as announced on December 27th including 81 already decided upon with the total likely in the range of about (inaudible) stores.
We are also working to reduce the assets deployed in our operations and are currently planning to reduce our peak inventory as disclosed in our December 27th release by between $500 million and $580 million. And we currently believe it will be in excess of that amount.
As Lou described, we intend to utilize our expense of customer royalty program known as Shop Your Way Rewards to establish digital relationships with our customers. We believe that this will allow us to become more efficient, meaning we can reduce the marketing expense by interacting with customers directly, more effective by providing targeted offers to our customers and more variable by reducing the fixed portion of our cost structure.
Accordingly, the investments we have made and continue to make in our member program we allow us to reduce our core marketing fixed spend by $100 million in 2012 versus prior year. We also currently plan to reengineer our $20 billion of annual merchandise spend over the next two years as part of an overall program to address our margins.
This concludes my comments on our operations. Now, I will move on to our funding strategy. While we continue to be focused on improving our operating performance its important to note that we are an asset rich enterprise with multiple resources at our disposal which we believe provides us with ample financial flexibility. It is important to distinguish between our operating performance and the unrecognized value in our asset portfolio; our substantial liquidity and financial flexibility.
With this in mind, I want to take a few minutes to walk you through our funding strategy and liquidity. Consistent with my comments about the value of our real estate portfolio and the unrecognized value of our asset portfolio, today we announced an agreement for the sale of 11 stores. This will result in net after-tax proceeds of about $270 million expected in the next 60 days.
We believe that this action taken together with the $400 million to $500 million we expect to receive in connection with the transfer of our Sears Hometown and Outlet businesses and certain hardware stores demonstrates the nature of the unrecognized value inherent in our portfolio of assets. As I will show later on these actions add to our already ample liquidity.
Moving to the asset summary on page 15, as of the end of the fourth quarter we had more than $3 billion in liquidity with minimal debt maturities until 2018. Our assets include $8.4 billion of inventory and extensive borrowing base supported by our inventory, owned and leased real estate, market leading proprietary brands such as Kenmore, Craftsman and DieHard, standalone businesses such as Lands’ End and Sears Canada, other businesses and assets with a standalone nature such as Sears Hometown and Outlet businesses and certain hardware stores. This asset portfolio provides us flexibility as we seek to transform our business.
Page 16 contains more detail on our capital structure with the main components of our debt being a $3.275 billion domestic revolving credit facility, until April 2016 that is secured by domestic inventory and receivables. Sears Canada has a similar $800 million Canadian revolver through 2015; $1.24 billion of senior secured notes due in 2018 and about $500 million of remaining Sears, Roebuck and Company debt from the merger.
The first point to make is that our debt is firmly in place for the next several years. Secondly, a few comments about our $3.275 billion domestic revolver. When we initially put a revolver in place back in 2005, the intention was not to use it solely to fund seasonal working capital needs, but forced to be the main portion of our debt.
As such, it does not include typical restrictions on usage. We can use it for almost any purpose including to fund acquisitions, make debt repayments, make pension contribution and other purposes. The owner restrictions relate to dividends and share repurchases.
Also the revolver is a very efficient form of borrowing for two reasons. The borrowing rate is very cost effective. It is LIBOR plus 250 basis points, so we are currently paying about 2.75% interest rate on borrowing. The cost of the revolver feature, we only pay that interest when we draw on the facility.
The revolver has no active financial covenant. There is only a spring covenant which arises if and only if we were to fall below 10% availability. This is something we can manage and for reference, at our peak this past year, our availability was in excess of 25%.
My final point on the revolver has to do with the collateral which supports it. We have significant excess collateral. For that reason, we included in the revolver agreement a $1 billion accordion feature. This means, we have the ability to bring in additional lenders and give them the same first lien on the collateral which the existing lenders have.
We also have the ability to add $760 million of second lien financing. Our excess collateral coupled with the accordion and second lien feature provides us with flexibility to borrow additional funds if desired.
On page 17, is a summary of our debt balances. As you can see, when you compare the current year debt balance to what was reported last year, we actually reduced modestly our debt in 2011, despite the increase in revolver bond. Again, we view the revolver as one of our more efficient funding mechanisms.
As you can see in 2011, we use the revolver to fund $500 million in debt retirement, to invest $350 million in domestic pension and to make a $183 million in share repurchases, obviously which are discretionary item.
On page 18, we have $3.2 billion in liquidity as of year-end 2011 which allows us to use our revolver from more than just working capital.
On page 19, we summarized our future term debt maturities. As I noted, we have retired about a $1.5 billion of debt over the past year and we have additional maturities of the $170 million in 2012. After that, we have minimal repayments until 2018.
Moving to the current assets on page 20, we have $754 million in cash in Sears and Sears Canada as of year end 2011. That merchandize is about $5.5 billion as our $8.4 billion of inventory is partially offset by $2.9 billion of payable. This is an important point. In other words, $5.5 billion of our inventory is already bought and paid for. We have sharpened our focus to manage our inventory and payables closely to improve our productivity and increase our return on invested capital.
We have already made nice progress in reducing our inventory investment as inventory is down $544 million from last year while payables declined $134 million representing about $410 million source of cash. $420 million of the inventory decline was domestic, $123 million of inventory decline was in Sears Canada. Inventory productivity will be a main focus in 2012 and we currently plan to realize further reductions in the October-November peak periods in excess of the $500 million to $580 million previously indicated in the December 27 release.
On page 21, you can see the degree of our excess collateral. The inventory and other collateral are subject to a borrowing base formula which provides an advanced rate of approximately 70% on eligible inventory. This chart summarizes the collateral as valued by the borrowing base formula. As background, the collateral range between $4.9 billion to over $6.6 billion during the fiscal year 2011 depending on our inventory levels. We show two sources of debt on this chart, the $1.24 billion of 2018 senior secured notes and the $3.275 billion revolving credit facility.
Even at our peak borrowing period in October of 2011, we had $2.8 billion of excess collateral as determined by the borrowings base formula. You will also note that at our peak, we had $1.8 billion of excess credit available and as of the year ended January, it was $2.5 billion of availability. So as you can see, there is substantial collateral and credit availability. As indicated on page 22 and as announced separately today, we’ve reached an agreement which has been executed with General Growth Properties, a New York stock exchange listed real-estate investment trust for the sale of 11 of our stores for $270 million on proceeds. We expect to realize those proceeds in the next 60 days.
On page 23, you can note the business of our hometown hardware and outlet stores. In the past, there has been much discussion about the value of the underlying assets at Sears Holdings. We’ve had many conversations internally about the best way to begin to unlock some of that value. The combined business as you can see represent about $2.3 billion to 2.6 billion in revenue between $70 million and $80 million in EBITDA and $350 million to $400 million in assets and $325 million to $375 million in net inventory.
We’ve begun exploring alternatives on locking that value and as Lou indicated we’ve settled on the approach than involves the transfer of direct ownership in these business as a separate company to electing shareholders. As you know, we recently spun off Orchard Supply as part of our plan to unlock value and focus more on our core businesses.
Sears Hometown and Outlet businesses and certain hardware stores reflects a next step in unlocking value in our portfolio of assets and allowing those businesses to pursue a more singular focus of their strategy. We expect to realize approximately $400 million to $500 million in proceeds from this transaction. ESL Investments, our controlling shareholder who owns 61% of Sears Holdings is supportive of the transaction. We issued the press release today announcing this transaction and will keep you apprised as the transaction progresses.
On slide 24, we show an outline of how one might think about our seasonal borrowing needs. At the beginning of 2011, we were undrawn under our revolver facility. In October 2011, which is roughly our peak borrowing season, we disclosed we had $1.65 billion revolver outstanding. Including letters of credit, this was less than 75% utilization meaning we had an excess of 25% availability.
In considering 2012, we need to make some adjustments, absent any changes in EBITDA to illustrate our revolver borrowings. First, in the December 27 release, we indicated that we expected to reduce our peak inventory in 2012 by $500 million to $580 million and to reduce our peak borrowings by $350 million from levels that may have resulted absent such actions. We now currently plan to reduce our peak inventory by an amount in excess of that initial range.
Second, as we discussed we are retiring $300 million less debt this year than last year. Third, we currently expect based on market conditions and other factors that the distribution of rights may generate about $400 million to $500 million. And finally, the announced agreement for the real estate transaction is expected to generate $270 million of proceeds in the next 60 days.
So, in this example, we believe the actions listed here would reduce the borrowing need from the beginning of our fiscal year and our third quarter by about $1.4 billion absent any changes in EBITDA performance for the year. Assuming this had happened in 2011, our increase from January through October would have been approximately $230 million to $330 million.
So, in summary, we have more than ample liquidity. We are focused on improving our operating performance. Today, we have outlined several actions already been executed again in the areas of cost reductions and margin improvement.
In addition, we have begun to execute on inventory management initiative and transactions unlocking the value in the portfolio of our assets, which together are expected to generate over $1 billion in capital.
With that, let me turn the call over to Ron Boire.
Ron Boire - EVP, Chief Merchandising and President, Sears and Kmart Formats
Thanks Rob and I am delighted to be here and on this call. I joined Sears because I felt the company had enormous untapped potential in its brands, in its vendor relationships, in its real estate, in its people and in its members. I’ve been impressed on several fronts since joining the company a few weeks ago. I’ll discuss three of these.
First, the level of investment in and focus on creating a differentiated, integrated retail experience for our members is extraordinary. Second, I have been impressed by the commitment of leadership and our owners to the transformation of our company and our brands and third the team here is ready to win.
My focus is on executing our integrated retail strategy envision and creating a culture of excellence in our stores and through our merchandising. To that point I would like to address some of my initial observations. First we must build a customer-focused selling culture in our stores to the integrated retail process.
By leveraging our investments and technology, we can provide customers with better and more timely information and service no matter where or when they choose to shop. Our objective must be to make every member visit an extraordinary event letting them shop their way and be rewarded for it.
For example, our appliance and electronics customers can receive a shopper recap electronically after visiting a store which allows them to review the items they were shopping for at home and purchase them with just a click of the mouse.
Second, from a structural point of view we have the opportunity to leverage our categories and brands in a very different way from our competitors, but breadth and depth of our offering from Hardlines to home and apparel not only is a differentiator for our SHOP YOUR WAY REWARDS program, but also provides many opportunities to improve adjacencies and cross merchandising.
One simple example of this is our strength in tools and work groups where we have market leading positions, yet failed to leverage this in our messaging and merchandising. Our customer should experience a compelling workwear and footwear presentation when he is shopping for tools. Another example is our apparel and electronics businesses. We sell millions of garments each year when mom comes to the store, makes a purchase and exits without ever seeing or experiencing some of our great electronics brands. We have the opportunity to outpost products such as headphones and our apparel and sporting goods departments that appeal to our core customers in those categories. Today headphones are as much a fashion statement as a music accessory. Likewise we brought in new Softline brands and will distort our key brands that offer quality fashions to Kmart and Sears customers.
Our Hardlines business have the reputation for quality and innovation that we need to extend to the whole box. In doing so, we will sell a broader more compelling offering to our customers. These are small but powerful examples of some of the vast merchandising opportunities we have and ways that we can create a differentiated shopping experience for our members in our customers.
We are also focused on continuing our longstanding tradition of great brands and innovative products. This year for example we will introduce new products and technologies in our core brands like Kenmore and Craftsman as well as launch new brands designed to leverage our strength.
In our market leading Kenmore brand, introductions include large capacity and timesaving innovations. In Q1 we are introducing a new large capacity refrigerator line such as our Kenmore 31 cubic foot grab and go, with exclusive indoor design in the industry’s largest front store platform. We are also introducing timesaving frontload washers like the Kenmore Elite frontload with a seller wash, which provides over 35% faster wash cycles to get clothes clear, faster and our successful Craftsman Turn Tight tractors will now feature an industry best six-inch turning radius for faster easier mowing.
In apparel Kmart, we’ll extend our strength in men’s through the launch of our new Legend 1, big men’s casual fashion brand targeted 25 to 35 year old customers. And Heritage Nations an updated men denim brand was launched in Q4. Both of these new brands were developed at our New York design chain.
These are just a few of the many product and brand launches we will execute in 2012 to further enhance our portfolio of brands and continue to bring innovations to market that improve our customer’s lives.
In addition to our focus on selling culture and leveraging our proprietary brands we intend to make our stores easier to navigate and more interactive. With great brand positions and diverse categories from home appliances and fitness to tools and apparel, our customers has many options when entering our stores and we need to do a better job in guiding them through the experience or improving the experience itself.
While I am still relatively new, what I’ve seen in my first two weeks has only confirmed my beliefs the Sears holding is extremely well-positioned to lead the integrated retail revolution in the US. We have world class brands; a solid store base; a strong and growing social, local, mobile and online infrastructure; great people; and most importantly millions of loyal customers who love our brands and are waiting for us to take our integrated experience to the next level.
Now, I would like to hand the call off to Bill Phelan.
Bill Phelan - SVP, Finance
Thank you, Ron. Operator we now like to open up the line for questions and answers.
|
|
Fund Letters
