Attached files

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EX-32 - EXHIBIT 32 - SEARS HOMETOWN & OUTLET STORES, INC.shos-072917xex32.htm
EX-31.2 - EXHIBIT 31.2 - SEARS HOMETOWN & OUTLET STORES, INC.shos-072917xex312.htm
EX-31.1 - EXHIBIT 31.1 - SEARS HOMETOWN & OUTLET STORES, INC.shos-072917xex311.htm
EX-10.4 - EXHIBIT 10.4 - SEARS HOMETOWN & OUTLET STORES, INC.shos-072917xex104.htm
EX-10.3 - EXHIBIT 10.3 - SEARS HOMETOWN & OUTLET STORES, INC.shos-072917xex103.htm
EX-10.2 - EXHIBIT 10.2 - SEARS HOMETOWN & OUTLET STORES, INC.shos-072917xex102.htm
EX-10.1 - EXHIBIT 10.1 - SEARS HOMETOWN & OUTLET STORES, INC.shos-072917xex101.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549 
_______________________________________________
FORM 10-Q
_______________________________________________ 
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
FOR THE QUARTERLY PERIOD ENDED JULY 29, 2017
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-35641 
_______________________________________________
SEARS HOMETOWN AND OUTLET STORES, INC.
(Exact Name of Registrant as Specified in Its Charter)
_______________________________________________
DELAWARE
 
80-0808358
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)
 
 
5500 TRILLIUM BOULEVARD, SUITE 501 HOFFMAN ESTATES, ILLINOIS
 
60192
(Address of Principal Executive Offices)
 
(Zip Code)
Registrant’s Telephone Number, Including Area Code: (847) 286-7000 
_______________________________________________
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
 
¨ 
  
Accelerated filer
 
ý
 
 
 
 
Non-accelerated filer (Do not check if a smaller reporting company)
 
                     ¨ 

  
Smaller reporting company
 
¨
 
 
 
 
 
 
 
 
 
 
 
Emerging growth company
 
¨


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




Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
As of September 5, 2017 the registrant had 22,702,132 shares of common stock, par value $0.01 per share, outstanding.
 



SEARS HOMETOWN AND OUTLET STORES, INC.
INDEX TO QUARTERLY REPORT ON FORM 10-Q
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016
 
 
 
 
 
Page
 
 
PART I—FINANCIAL INFORMATION
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
PART II—OTHER INFORMATION
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.




SEARS HOMETOWN AND OUTLET STORES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
 
 
 
13 Weeks Ended
 
26 Weeks Ended
Thousands, except per share amounts
 
July 29, 2017
 
July 30, 2016
 
July 29, 2017
 
July 30, 2016
NET SALES
 
$
489,985

 
$
556,388

 
$
938,218

 
$
1,093,369

COSTS AND EXPENSES
 
 
 
 
 
 
 
 
Cost of sales and occupancy
 
397,637

 
441,508

 
752,115

 
862,298

Selling and administrative
 
115,208

 
118,808

 
226,089

 
236,800

Depreciation and amortization
 
4,704

 
3,293

 
6,908

 
6,550

Gain on sale of assets
 

 
(25,269
)
 

 
(25,269
)
Total costs and expenses
 
517,549

 
538,340

 
985,112

 
1,080,379

Operating (loss) income
 
(27,564
)
 
18,048

 
(46,894
)
 
12,990

Interest expense
 
(1,874
)
 
(886
)
 
(3,465
)
 
(1,652
)
Other income
 
231

 
378

 
550

 
775

(Loss) earnings before income taxes
 
(29,207
)
 
17,540

 
(49,809
)
 
12,113

Income tax expense
 
(239
)
 
(6,898
)
 
(1,071
)
 
(5,042
)
NET (LOSS) INCOME
 
$
(29,446
)
 
$
10,642

 
$
(50,880
)
 
$
7,071

 
 
 
 
 
 
 
 
 
NET (LOSS) INCOME PER COMMON SHARE ATTRIBUTABLE TO STOCKHOLDERS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic:
 
$
(1.30
)
 
$
0.47

 
$
(2.24
)
 
$
0.31

Diluted:
 
$
(1.30
)
 
$
0.47

 
$
(2.24
)
 
$
0.31

 
 
 
 
 
 
 
 
 
Basic weighted average common shares outstanding
 
22,702

 
22,696

 
22,702

 
22,681

Diluted weighted average common shares outstanding
 
22,702

 
22,699

 
22,702

 
22,682

See Notes to Condensed Consolidated Financial Statements.


1


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

Thousands
 
July 29, 2017
 
July 30, 2016
 
January 28, 2017
ASSETS
 
 
 
 
 
 
CURRENT ASSETS
 
 
 
 
 
 
Cash and cash equivalents
 
$
18,287

 
$
18,690

 
$
14,104

Accounts and franchisee receivables, net
 
10,920

 
17,017

 
11,448

Merchandise inventories
 
356,893

 
427,234

 
373,815

Prepaid expenses and other current assets
 
9,995

 
18,562

 
9,370

Total current assets
 
396,095

 
481,503

 
408,737

PROPERTY AND EQUIPMENT, net
 
39,236

 
50,898

 
40,935

LONG-TERM DEFERRED TAXES
 

 
74,984

 

OTHER ASSETS, net
 
11,112

 
15,493

 
18,754

TOTAL ASSETS
 
$
446,443

 
$
622,878

 
$
468,426

LIABILITIES
 
 
 
 
 
 
CURRENT LIABILITIES
 
 
 
 
 
 
Short-term borrowings
 
$
112,400

 
$
70,400

 
$
26,800

Payable to Sears Holdings Corporation
 
24,764

 
34,868

 
80,724

Accounts payable
 
11,408

 
38,418

 
17,853

Other current liabilities
 
75,777

 
66,667

 
70,377

Total current liabilities
 
224,349

 
210,353

 
195,754

OTHER LONG-TERM LIABILITIES
 
2,378

 
2,868

 
1,973

TOTAL LIABILITIES
 
226,727

 
213,221

 
197,727

COMMITMENTS AND CONTINGENCIES (Note 9)
 

 

 

STOCKHOLDERS' EQUITY
 
 
 
 
 
 
TOTAL STOCKHOLDERS' EQUITY
 
219,716

 
409,657

 
270,699

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
446,443

 
$
622,878

 
$
468,426

See Notes to Condensed Consolidated Financial Statements.


2


SEARS HOMETOWN AND OUTLET STORES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
 
26 Weeks Ended
Thousands
 
July 29, 2017
 
July 30, 2016
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
 
Net (loss) income
 
$
(50,880
)
 
$
7,071

Adjustments to reconcile net (loss) income to net cash used in operating activities:
 
 
 
 
Depreciation and amortization
 
6,908

 
6,550

Share-based compensation
 
(103
)
 
77

Deferred income taxes
 

 
4,158

Gain on sale of assets
 

 
(25,269
)
Provision for losses on franchisee receivables
 
5,701

 
(483
)
Change in operating assets and liabilities:
 
 
 
 
Accounts and franchisee receivables
 
676

 
(4,165
)
Merchandise inventories
 
16,922

 
7,612

Payable to Sears Holdings Corporation
 
(55,960
)
 
(19,258
)
Accounts payable
 
(6,445
)
 
(1,344
)
Closing store accrual
 
1,714

 
105

Other operating assets and liabilities, net
 
4,781

 
3,725

Net cash used in operating activities
 
(76,686
)
 
(21,221
)
CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
 
Proceeds from the sale of assets
 

 
26,073

Purchases of property and equipment
 
(4,641
)
 
(6,838
)
Net cash (used in) provided by investing activities
 
(4,641
)
 
19,235

CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
 
Net short-term borrowings
 
85,600

 
2,100

Net (payments) borrowings of capital lease obligations
 
(90
)
 
332

Net cash provided by financing activities
 
85,510

 
2,432

NET CHANGE IN CASH AND CASH EQUIVALENTS
 
4,183

 
446

CASH AND CASH EQUIVALENTS—Beginning of period
 
14,104

 
18,244

CASH AND CASH EQUIVALENTS—End of period
 
$
18,287

 
$
18,690

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
 
 
 
 
Cash paid for interest
 
$
3,480

 
$
1,678

Cash paid (refunded) for income taxes
 
$
572

 
$
(1,845
)
See Notes to Condensed Consolidated Financial Statements.


3


SEARS HOMETOWN AND OUTLET STORES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited)
 
Thousands
Number of Shares of Common Stock
 
Common Stock/Par Value
 
Capital in Excess of Par Value
 
Accumulated Deficit
 
Total Stockholders' Equity
Balance at January 30, 2016
22,722

 
$
227

 
$
555,372

 
$
(153,090
)
 
$
402,509

Net income

 

 

 
7,071

 
7,071

Share-based compensation
(6
)
 

 
77

 

 
77

Balance at July 30, 2016
22,716

 
$
227

 
$
555,449

 
$
(146,019
)
 
$
409,657

 
 
 
 
 
 
 
 
 
 
Balance at January 28, 2017
22,716

 
$
227

 
$
555,481

 
$
(285,009
)
 
$
270,699

Net loss

 

 

 
(50,880
)
 
(50,880
)
Share-based compensation
(14
)
 

 
(103
)
 

 
(103
)
Balance at July 29, 2017
22,702

 
$
227

 
$
555,378

 
$
(335,889
)
 
$
219,716

See Notes to Condensed Consolidated Financial Statements.



4

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


NOTE 1—BACKGROUND AND BASIS OF PRESENTATION
Background
Sears Hometown and Outlet Stores, Inc. is a national retailer primarily focused on selling home appliances, lawn and garden equipment, and tools. As of July 29, 2017 the Company or its dealers and franchisees operated a total of 932 stores across all 50 states and in Puerto Rico and Bermuda. In these notes and elsewhere in this Quarterly Report on Form 10-Q the terms “we,” “us,” “our,” “SHO,” and the “Company” refer to Sears Hometown and Outlet Stores, Inc. and its subsidiaries.
Our common stock trades on the NASDAQ Stock Market under the trading symbol “SHOS.”
The Separation
The Company separated from Sears Holdings Corporation (“Sears Holdings”) in October 2012 (the “Separation”). To our knowledge Sears Holdings does not own any shares of our common stock. The Company has specified rights to use the "Sears" name under a license agreement from Sears Holdings.
Basis of Presentation

These unaudited Condensed Consolidated Financial Statements include the accounts of Sears Hometown and Outlet Stores, Inc. and its subsidiaries, all of which are wholly owned. These unaudited Condensed Consolidated Financial Statements do not include all of the information and footnotes required in annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the 13 and 26 weeks ended July 29, 2017 are not necessarily indicative of the results that may be expected for the full fiscal year. These financial statements and related notes should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended January 28, 2017 (the "2016 10-K").
We operate through two segments--our Sears Hometown segment ("Hometown") and our Sears Outlet segment ("Outlet").
Our second fiscal-quarter end is the Saturday closest to July 31 each year.  Our fiscal-year end is the Saturday closest to January 31 each year.
Reclassifications- certain amounts have been reclassified in order to conform to the current period presentation.
Variable Interest Entities and Consolidation
The Financial Accounting Standards Board ("FASB") has issued guidance on variable interest entities and consolidation for determining whether an entity is a variable interest entity ("VIE") as well as the methods permitted for determining the primary beneficiary of a variable interest entity. In addition, this guidance requires ongoing reassessments as to whether a reporting company is the primary beneficiary of a variable interest entity and disclosures regarding the reporting company’s involvement with a variable interest entity.
On an ongoing basis the Company evaluates its business relationships, such as those with its independent dealers, independent franchisees, and suppliers, to identify potential variable interest entities. Generally, these businesses either qualify for a scope exception under the consolidation guidance or, where a variable interest exists, the Company does not possess the power to direct the activities that most significantly impact the economic performance of these businesses. The Company has not consolidated any of such entities in the periods presented.
Fair Value of Financial Instruments
We determine the fair value of financial instruments in accordance with standards pertaining to fair value measurements. Such standards define fair value and establish a framework for measuring fair value under GAAP. Under fair value measurement accounting standards, fair value is considered to be the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. We report the fair value of financial assets and liabilities based on the fair value hierarchy prescribed by accounting standards for fair value measurements, which prioritizes the inputs to valuation techniques used to measure fair value into three levels, as follows:
Level 1 inputs—unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. An active market for the asset or liability is one in which transactions for the asset or liability occurs with sufficient frequency and volume to provide ongoing pricing information.

5

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


Level 2 inputs—inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly, for the asset or liability. Level 2 inputs include, but are not limited to, quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted market prices that are observable for the asset or liability, such as interest-rate curves and yield curves observable at commonly quoted intervals, volatilities, credit risks, and default rates.
Level 3 inputs—unobservable inputs for the asset or liability.
Cash and cash equivalents, merchandise payables, accrued expenses (level 1), accounts and franchisee notes receivable, and short-term debt (level 2) are reflected in the Condensed Consolidated Balance Sheets at cost, which approximates fair value due to the short-term nature of these instruments. For short-term debt, the variable interest rates are a significant input in our fair value assessments. The carrying value of long-term notes receivable approximates fair value.
We measure certain non-financial assets and liabilities, including long-lived assets, at fair value on a nonrecurring basis.
    
The Company was not required to measure any other significant non-financial asset or liability at fair value as of July 29, 2017.
Recent Accounting Pronouncements
ASU 2017-01 "Business Combinations (Topic 805): Clarifying the Definition of Business"
In January 2017, the FASB issued ASU No. 2017-01 "Business Combinations (Topic 805): Clarifying the Definition of Business". This ASU is meant to clarify the definition of a business to add guidance when determining when an acquisition or disposal should be accounted for as a sale of assets or business. This ASU provides a more robust framework to use in determining when a set of assets or activities should be classified as a business, providing more consistency in accounting for business or asset acquisitions. This ASU is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those periods. The ASU will be applied prospectively.

ASU 2016-15 "Statement of Cash Flows (Topic 230) Classification of Certain Cash Receipts and Cash Payments"
In August 2016, the FASB issued ASU No. 2016-15, "Classification of Certain Cash Receipts and Cash Payments". This ASU reduces the diversity in reporting of eight specific cash flow issues due to accounting guidance that is unclear or does not exist. The eight issues relate to certain debt activities, business combination activities, insurance settlements and other various activities. This guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. Early adoption is permitted and is to be applied retrospectively using a transition method for each period presented. An entity that elects early adoption of the amendment under this ASU must adopt all aspects of the amendment in the same period. This guidance is not expected to have a material impact on our consolidated financial statements.

ASU 2016-02 "Leases (Topic 842)"
In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)". This amendment created a new Topic under the accounting standards codification to account for the provisions of the ASU. This amendment is meant to provide transparency and to improve comparability between entities. The ASU requires companies to record an asset and liability on the balance sheet for leases that were formerly designated as operating leases as well as leases designated as financing leases. The provisions of the ASU predominately change the recognition of leases for lessees, but the provisions do not substantially change the accounting for lessors. This ASU will supersede the provisions of Topic 840 Leases.

The liability recorded for a lease is generally intended to recognize the present value of lease payments and the asset as a right to use the underlying asset for the lease, including optional periods if it is reasonably certain the option will be exercised. If a lease term is less than twelve months, a company is allowed to elect not to record the asset and liability. Expense related to these leases are to be amortized straight-line over the expected term of the lease.

Additionally, the provisions of this ASU provide additional guidance on separating lease terms from maintenance and other type of provisions that provide a good or service, accounting for sale-leaseback provisions, and leveraged leases.

These updates are required to be applied under a modified retrospective approach from the beginning of the earlier period presented. The modified approach provides optional practical expedients that may be elected, which will allow companies to continue to account for leases under the previous guidance for leases that commenced prior to the effective date. Reporting in the cash flow statement remains virtually unchanged. Additional qualitative and quantitative disclosures are required.


6

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


The provisions of this ASU are effective for fiscal years beginning after December 15, 2018, and interim periods within those periods. Early adoption is allowed. We have just commenced the process for evaluating the impact of this ASU on our financial statements, and therefore it's impact has not yet been determined. However, upon adoption, we expect that the right of use asset and the lease liability will be recognized in the balance sheets in amounts that will be material.

ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)"
In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)". The guidance in this ASU affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts). The new revenue recognition guidance more closely aligns U.S. GAAP with International Financial Reporting Standards ("IFRS"). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

In August 2015, the FASB issued ASU 2015-14: Accounting for Revenue from Contracts with Customers (Topic 606)The amended guidance deferred the effective date of ASU 2014-9 to annual periods beginning after December 15, 2017 and interim periods within those fiscal years. Early adoption is permitted for annual periods beginning after December 15, 2016 and interim periods within those fiscal years. In addition, four other ASUs have been issued amending and clarifying ASU 2014-09 and must be adopted concurrently.

ASU 2016-08 "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)
ASU 2016-10 "Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing"
ASU 2016-12 "Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients"
ASU 2016-20 "Revenue from Contracts with Customers (Topic 606): Technical Corrections and Improvements"

This update can either be applied under a cumulative effect or retrospective method. We are in the process of reviewing customer contracts and agreements to determine the potential effects of the standard based on our revenue streams and current revenue recognition practices. Following review of customer contracts and agreements, we will summarize contract terms, reference the findings to the applicable new guidance, determine the financial statement impact, and then update policies and controls to ensure application of the new provisions will be applied consistently throughout the Company. As we are still in the process of completing our full assessment of the impact expected from adoption of this standard, we have not yet determined the materiality of the resulting differences in the timing of revenue recognition. The Company expects to adopt the provisions of this standard using the modified retrospective approach, which requires a cumulative effect adjustment to the opening balance of retained earnings on the date of adoption. The Company will adopt ASU 2014-09 effective February 4, 2018.


7

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


NOTE 2—ACCOUNTS AND FRANCHISEE RECEIVABLES AND OTHER ASSETS
Accounts and franchisee receivables and other assets consist of the following:
 
Thousands
 
July 29, 2017
 
July 30, 2016
 
January 28, 2017
Short-term franchisee receivables
 
$
1,584

 
$
2,262

 
$
1,920

Miscellaneous receivables
 
10,363

 
16,018

 
10,475

Long-term franchisee receivables
 
11,260

 
20,971

 
18,406

Other assets
 
5,851

 
3,822

 
7,643

Allowance for losses on short-term franchisee receivables (1)
 
(1,027
)
 
(1,263
)
 
(947
)
Allowance for losses on long-term franchisee receivables (1)
 
(5,999
)
 
(9,300
)
 
(7,295
)
Net accounts and franchisee receivables and other assets
 
$
22,032

 
$
32,510

 
$
30,202


(1) The Company recognizes an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs and existing economic conditions and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling and administrative expense. Most of our franchisee promissory notes authorize us to deduct debt service from our commissions otherwise due and payable to the franchisees, and we routinely make those deductions to the extent of available commissions payable.
NOTE 3—ALLOWANCE FOR LOSSES ON FRANCHISEE RECEIVABLES
The allowance for losses on franchisee receivables consists of the following as of:  
 
26 Weeks Ended
Thousands
July 29, 2017
 
July 30, 2016
Allowance for losses on franchisee receivables, beginning of period
$
8,242

 
$
12,141

Provisions (recoveries) during the period
5,701

 
(483
)
Write off of franchisee receivables against the allowance
(6,917
)
 
(1,220
)
Other

 
125

Allowance for losses on franchisee receivables, end of period
$
7,026

 
$
10,563


During the 13 weeks ended July 29, 2017, the Company and a franchisee entered into agreements that terminated all of the franchisee's franchise agreements and sublease arrangements for 14 franchised locations (except with respect to one location as to which the Company would either assume the lease or enter into a lease directly with the landlord). The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases (in one instance pursuant to an Occupancy Agreement). The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $5.5 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes and received a new promissory note from the franchisee in the amount of $1.5 million, which is payable in installments through December 11, 2022. During the 13 weeks ended July 29, 2017, the Company recognized a loss of $5.5 million on the transaction.


8

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


NOTE 4—OTHER CURRENT AND LONG-TERM LIABILITIES
Other current and long-term liabilities consist of the following:
 
Thousands
July 29, 2017
 
July 30, 2016
 
January 28, 2017
Customer deposits
$
19,645

 
$
25,350

 
$
19,943

Sales and other taxes
11,256

 
11,753

 
11,380

Accrued expenses
30,923

 
26,335

 
27,602

Payroll and related items
6,958

 
5,203

 
5,766

Store closing costs
9,373

 
894

 
7,659

Total Other current and long-term liabilities
$
78,155

 
$
69,535

 
$
72,350

NOTE 5—INCOME TAXES
SHO and Sears Holdings entered into a Tax Sharing Agreement that governs the rights and obligations of the parties with respect to pre-Separation and post-Separation tax matters. Under the Tax Sharing Agreement, Sears Holdings generally is responsible for any federal, state, or foreign income tax liability relating to tax periods ending on or before the Separation. For all periods after the Separation, the Company generally is responsible for any federal, state, or foreign tax liability. Current income taxes payable for any federal, state, or foreign income tax returns is reported in the period incurred.
We account for uncertainties in income taxes according to accounting standards for uncertain tax positions. The Company is present in a large number of taxable jurisdictions and, at any point in time, can have tax audits underway at various stages of completion in one or more of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite our belief that the underlying tax positions are fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closings of statutes of limitation. Such adjustments are reflected in the tax provision as appropriate. For the 13 and 26 Weeks ended July 29, 2017 and July 30, 2016, no unrecognized tax benefits have been identified and reflected in the Condensed Consolidated Financial Statements.
 
We classify interest expense and penalties related to unrecognized tax benefits and interest income on tax overpayments as components of income tax expense. As no unrecognized tax benefits have been identified and reflected in the Condensed Consolidated Financial Statements, no interest or penalties related to unrecognized tax benefits are reflected in the Condensed Consolidated Balance Sheets or Statements of Operations.

Management assesses the available positive and negative evidence to estimate whether sufficient future taxable income will be generated to realize the benefit of the existing deferred tax assets. A significant piece of objective negative evidence evaluated was the cumulative loss for the three years ended January 28, 2017. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future income. On the basis of this analysis, management has established a full valuation allowance to offset the net deferred tax assets that are not expected to be realized. Management will continue to evaluate objective and subjective evidence for changes in circumstances that cause a change in judgment about the realizability of the deferred tax assets.

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

9

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


NOTE 6—RELATED-PARTY AGREEMENTS AND TRANSACTIONS

According to publicly available information ESL Investments, Inc. and investment affiliates including Edward S. Lampert (collectively, "ESL") beneficially own approximately 57% of our outstanding shares of common stock and approximately 49% of Sears Holdings' outstanding shares of common stock (the latter percentage amount excludes shares that may be acquired within 60 days upon the exercise of warrants to purchase shares). Mr. Lampert is the Chairman of the Board and Chief Executive Officer of Sears Holdings.
SHO and Sears Holdings (and in some circumstances, its subsidiaries) have entered into various agreements (as amended, the "SHO-Sears Holdings Agreements") that, among other things, (1) govern specified aspects of our relationship with Sears Holdings, (2) establish terms under which subsidiaries of Sears Holdings provide services to us, and (3) establish terms pursuant to which subsidiaries of Sears Holdings obtain merchandise inventories for us. The terms of the SHO-Sears Holdings Agreements were agreed to prior to the Separation (except for amendments entered into after the Separation that were approved by the Audit Committee of SHO's Board of Directors) in the context of a parent-subsidiary relationship and in the overall context of the Separation. The costs and allocations charged to the Company by Sears Holdings do not necessarily reflect the costs of obtaining the services from unaffiliated third parties or of the Company itself providing the applicable services. The Company has engaged in frequent discussions, and has resolved disputes, with Sears Holdings about the terms and conditions of the SHO-Sears Holdings Agreements, the business relationships that are reflected in the SHO-Sears Holdings Agreements, and the details of these business relationships, many of which details had not been addressed by the terms and conditions of the SHO-Sears Holdings Agreements or, if addressed, in the past were, and in the future could be, in dispute as to their meaning or application in the context of the existing business relationships. Many of these discussions have resulted in adjustments to the relationships that the Company believes together are in Company's best interests. On May 11, 2016, SHO and Sears Holdings entered into amendments to most of the SHO-Sears Holdings Agreements. The amendments are referred to in our Current Report on Form 8-K (File No. 001-35641) filed with the Securities and Exchange Commission on May 17, 2016. We also filed a Current Report on Form 8-K (File No. 001-35641) with the Securities and Exchange Commission on March 9, 2017 regarding the Amendment to Amended and Restated Merchandising Agreement dated as of March 8, 2017 among the Company, Sears Holdings, and Stanley Black & Decker. Inc.
The following is a summary of the nature of the related-party transactions between SHO and Sears Holdings:

SHO receives commissions from Sears Holdings for specified online sales, sales of extended service contracts, and sales of delivery and handling services, and commissions relating to the use in our stores of credit cards branded with the Sears name. For specified transactions SHO pays commissions to Sears Holdings.
We obtain a significant amount of our merchandise inventories from Sears Holdings.
We pay royalties related to our sale of products branded with the KENMORE®, CRAFTSMAN®, and DIEHARD® marks (which marks are owned by, or licensed to, subsidiaries of Sears Holdings, together the "KCD Marks"). The royalty rates vary but none exceeds 6%.
We pay fees for participation in Sears Holdings' SHOP YOUR WAY REWARDS® program.
We pay fees to Sears Holdings for logistics, handling, warehouse, and transportation services, which fees are based generally on merchandise inventory units.
Sears Holdings provides the Company with specified corporate services. These services include accounting and finance, and information technology, among other services. Sears Holdings charges the Company for these corporate services based on actual usage or pro rata charges based upon sales or other measurements.
Sears Holdings leases stores and distribution/repair facilities to the Company, for which the Company pays rent and related occupancy charges to Sears Holdings.
 
The following table summarizes the results of the transactions with Sears Holdings reflected in the Company’s Condensed Consolidated Financial Statements: 
 
 
13 Weeks Ended
 
26 Weeks Ended
 
 
July 29, 2017
 
July 30, 2016
 
July 29, 2017
 
July 30, 2016
Thousands
 
 
 
 
 
 
 
 
Net Commissions from Sears Holdings
 
$
18,448

 
$
22,818

 
$
35,485

 
$
44,392

Purchases related to cost of sales and occupancy
 
268,584

 
302,554

 
533,114

 
616,088

Services included in selling and administrative expense
 
17,370

 
18,864

 
33,903

 
40,312



10

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


We incur payables to Sears Holdings for merchandise inventory purchases and service and occupancy charges (net of commissions) based on the SHO-Sears Holdings Agreements.  Amounts due to or from Sears Holdings are non-interest bearing and, except as provided in the following sentences of this paragraph, are settled on a net basis and have payment terms of 10 days after the invoice date. In accordance with the SHO–Sears Holdings Agreements and at the request of Sears Holdings, the Company can pay invoices on two or three-day terms and receive a deduction on invoices for early–payment discounts of 37 to 43 basis points, respectively. The Company can, in its sole discretion, revert to ten–day, no–discount payment terms at any time upon notice to Sears Holdings. The discount received for payments made on accelerated terms, net of incremental interest expense, results in a net financial benefit to the Company. During 2017, the Company paid most invoices on either two or three–day terms and received discounts of $1.4 million and $2.0 million, for the 13 and 26 weeks ended July 29, 2017, respectively, which is reflected in the Condensed Consolidated Statements of Operations. During 2016, the Company began paying invoices on accelerated terms on May 1, 2016 and received discounts of $1.0 million during both the 13 and 26 weeks ended July 30, 2016, which is reflected in the Condensed Consolidated Statements of Operations.

We recorded real estate occupancy payments of $0.3 million and $0.6 million for the 13 and 26 weeks ended July 29, 2017, respectively, and $0.2 million and $0.4 million for the 13 and 26 weeks ended July 30, 2016, respectively, to Seritage Growth Properties, a real estate investment trust. Edward S. Lampert is the Chairman of the Board of Trustees of Seritage.
NOTE 7—FINANCING ARRANGEMENTS

In October 2012 the Company entered into a Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent, which provided (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the “Prior Facility”). Under the Prior Facility the Company initially borrowed $100 million which was used to pay a cash dividend to Sears Holdings prior to the Separation.
  
On November 1, 2016 the Company and its primary operating subsidiaries, entered into an Amended and Restated Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent and collateral agent, which provides (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the “Senior ABL Facility”). The Senior ABL Facility, which amended and restated the Prior Facility in its entirety, provides for extended revolving credit commitments in an aggregate amount equal to $170 million (the “Extended Revolving Credit Commitments”) and non-extended revolving credit commitments in an aggregate amount equal to $80 million (the “Non-Extended Revolving Credit Commitments”). The Extended Revolving Credit Commitments will mature on the earlier of (1) February 29, 2020 and (2) six months prior to the expiration of specified agreements entered into with Sears Holdings and its subsidiaries in connection with the Separation (the “Subject Agreements”) unless they are extended to a date later than February 29, 2020 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility. The Non-Extended Revolving Credit Commitments will mature on the earlier of (1) October 11, 2017 and (2) six months prior to the expiration of the Subject Agreements unless they are extended to a date later than October 11, 2017 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility. Costs related to and incurred for the November 1, 2016 refinancing totaled approximately $5.4 million, of which $4.4 million is remaining and is included in Prepaid and Other current assets on the Condensed Consolidated Balance Sheet as of July 29, 2017 and is being amortized over the remaining term of the Senior ABL Facility.

As of July 29, 2017 we had $112.4 million outstanding under the Senior ABL Facility, which approximated the fair value of these borrowings. Up to $75 million of the Senior ABL Facility is available for the issuance of letters of credit and up to $25 million is available for swingline loans. The Senior ABL Facility permits us to request commitment increases in an aggregate principal amount of up to $100 million. Availability under the Senior ABL Facility as of July 29, 2017 was $86.8 million, with $6.1 million of letters of credit outstanding under the facility. If the Non-Extended Revolving Credit Commitments had matured prior to the end of the second quarter of 2017, our availability under the Senior ABL Facility would have been approximately $52 million as of July 29, 2017.

In the first quarter of 2017, we resumed our agreement with Sears Holdings whereby SHO paid Sears Holdings' invoices for merchandise and services on accelerated terms in exchange for a 37 to 43 basis-point cash discount depending on the number of days we paid before the invoice due date. The Senior ABL Facility borrowings increased by approximately $23 million as of July 29, 2017, as a result of our accelerated payments. The discounts we received for the accelerated payments, less the incremental interest expense, resulted in a net financial benefit to the Company. During 2017, the Company paid most invoices on either two or three–day terms and received discounts totaling $1.4 million and $2.0 million for the 13 and 26 weeks ended July 29, 2017, respectively, which are reflected in the Condensed Consolidated Statements of Operations. During 2016, the Company began

11

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


paying invoices on accelerated terms on May 1, 2016 and received discounts totaling $1.0 million during both the 13 and 26 weeks ended July 30, 2016, which are reflected in the Condensed Consolidated Statements of Operations.

The principal terms of the Senior ABL Facility are summarized below.

Prepayments

The Senior ABL Facility is subject to mandatory prepayment in amounts equal to the amount by which the outstanding extensions of credit exceed the lesser of the borrowing base and the commitments then in effect.

Security and Guarantees

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

Interest; Fees

The interest rates per annum applicable to the loans under the Senior ABL Facility are based on a fluctuating rate of interest measured by reference to, at the Company’s election, either (1) an adjusted London inter-bank offered rate (LIBOR) plus a borrowing margin ranging from (x) 3.50% to 4.50%, in the case of the Extended Revolving Credit Commitments or (y) 2.00% to 2.50%, in the case of the Non-Extended Revolving Credit Commitments (which the blended rate was approximately 4.52% at July 29, 2017), and in each case based on availability under the Senior ABL Facility, or (2) an alternate base rate plus a borrowing margin, ranging from (x) 2.50% to 3.50%, in the case of the Extended Revolving Credit Commitments or (y) 1.00% to 1.50%, in the case of the Non-Extended Revolving Credit Commitments (which the blended rate was approximately 6.52% at July 29, 2017), and in each case based on availability under the Senior ABL Facility.

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

Covenants

The Senior ABL Facility includes a number of negative covenants that, among other things, limit or restrict the ability of the Company and its subsidiaries (including the guarantors) to, subject to certain exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make prepayments on other indebtedness, and engage in mergers or change the nature of the business of the Company and its subsidiaries (including the guarantors). In addition, upon excess availability falling below a specified level (which has not occurred), the Company is required to comply with a minimum fixed charge coverage ratio. The Senior ABL Facility also limits SHO’s ability to declare and pay cash dividends and to repurchase its common stock. The Senior ABL Facility would not have permitted us to pay cash dividends or repurchase our common stock as of July 29, 2017.

The Senior ABL Facility also contains affirmative covenants, including financial and other reporting requirements. As of July 29, 2017, SHO was in compliance with all covenants under the Senior ABL Facility.

Events of Default

The Senior ABL Facility includes customary and other events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments, change of control, failure to perform a “Material Contract” (which includes specified SHO-Sears Holdings Agreements) to the extent required to maintain it in full force and effect, failure to enforce a Material Contract in accordance with its terms, or termination by Sears Holdings of specified “Separation Agreements” (which include specified SHO-Sears Holdings Agreements).

12

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



NOTE 8—SUMMARY OF SEGMENT DATA

The Hometown reportable segment consists of the aggregation of our Hometown Stores, Hardware Stores, and Home Appliance Showrooms business formats described in “Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations-Executive Overview" of this Quarterly Report on Form 10-Q. The Outlet reportable segment also represents a business format. These segments are evaluated by our Chief Operating Decision Maker to make decisions about resource allocation and to assess performance. Each of these segments derives its revenues from the sale of merchandise and related services to customers, primarily in the U.S. Sales categories include appliances, lawn and garden, tools and paint, and other (which includes initial franchise revenue).
 
 
13 Weeks Ended July 29, 2017
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
222,513

 
$
116,655

 
$
339,168

Lawn and garden
 
81,237

 
5,697

 
86,934

Tools and paint
 
24,536

 
3,386

 
27,922

Other
 
19,354

 
16,607

 
35,961

Total
 
347,640

 
142,345

 
489,985

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
280,126

 
117,511

 
397,637

Selling and administrative
 
75,759

 
39,449

 
115,208

Depreciation and amortization
 
1,890

 
2,814

 
4,704

Total
 
357,775

 
159,774

 
517,549

Operating loss
 
$
(10,135
)
 
$
(17,429
)
 
$
(27,564
)
Total assets
 
$
297,553

 
$
148,890

 
$
446,443

Capital expenditures
 
$
1,096

 
$
1,469

 
$
2,565

 
 
 
13 Weeks Ended July 30, 2016
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
259,446

 
$
129,719

 
$
389,165

Lawn and garden
 
91,196

 
6,871

 
98,067

Tools and paint
 
31,369

 
4,355

 
35,724

Other
 
14,603

 
18,829

 
33,432

Total
 
396,614

 
159,774

 
556,388

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
313,231

 
128,277

 
441,508

Selling and administrative
 
83,554

 
35,254

 
118,808

Depreciation and amortization
 
1,507

 
1,786

 
3,293

Gain on sale of asset
 

 
(25,269
)
 
(25,269
)
Total
 
398,292

 
140,048

 
538,340

Operating income (loss)
 
$
(1,678
)
 
$
19,726

 
$
18,048

Total assets
 
$
415,501

 
$
207,377

 
$
622,878

Capital expenditures
 
$
3,268

 
$
1,280

 
$
4,548




13

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


 
 
26 Weeks Ended July 29, 2017
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
420,239

 
$
242,520

 
662,759

Lawn and garden
 
144,800

 
11,292

 
156,092

Tools and paint
 
49,823

 
7,266

 
57,089

Other
 
29,992

 
32,286

 
62,278

Total
 
644,854

 
293,364

 
938,218

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
510,000

 
242,115

 
752,115

Selling and administrative
 
150,176

 
75,913

 
226,089

Depreciation and amortization
 
2,745

 
4,163

 
6,908

Total
 
662,921

 
322,191

 
985,112

Operating loss
 
$
(18,067
)
 
$
(28,827
)
 
$
(46,894
)
Total assets
 
$
297,553

 
$
148,890

 
$
446,443

Capital expenditures
 
$
2,351

 
$
2,290

 
$
4,641


 
 
26 Weeks Ended July 30, 2016
Thousands
 
Hometown
 
Outlet
 
Total
Net sales
 
 
 
 
 
 
Appliances
 
$
490,380

 
$
271,767

 
$
762,147

Lawn and garden
 
169,613

 
11,559

 
181,172

Tools and paint
 
67,486

 
8,969

 
76,455

Other
 
35,714

 
37,881

 
73,595

Total
 
763,193

 
330,176

 
1,093,369

Costs and expenses
 
 
 
 
 
 
Cost of sales and occupancy
 
597,369

 
264,929

 
862,298

Selling and administrative
 
164,407

 
72,393

 
236,800

Depreciation and amortization
 
3,076

 
3,474

 
6,550

Gain on the sale of assets
 

 
(25,269
)
 
(25,269
)
Total
 
764,852

 
315,527

 
1,080,379

Operating income (loss)
 
$
(1,659
)
 
$
14,649

 
$
12,990

Total assets
 
$
415,501

 
$
207,377

 
$
622,878

Capital expenditures
 
$
4,574

 
$
2,264

 
$
6,838


NOTE 9—COMMITMENTS AND CONTINGENCIES
We are subject to various legal and governmental proceedings arising out of the ordinary course of business, the outcome of which, individually or in the aggregate, in the opinion of management would not have a material adverse effect on our business, financial position, results of operations, or cash flows.

14

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



NOTE 10— (LOSS) EARNINGS PER COMMON SHARE

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

The following table sets forth the components used to calculate basic and diluted loss per share attributable to our stockholders.
 
13 Weeks Ended
 
26 Weeks Ended
 
July 29, 2017
 
July 30, 2016
 
July 29, 2017
 
July 30, 2016
Thousands except income per common share
 
 
 
 
 
 
 
Basic weighted average shares
22,702

 
22,696

 
22,702

 
22,681

 
 
 
 
 
 
 
 
Diluted weighted average shares
22,702

 
22,699

 
22,702

 
22,682

 
 
 
 
 
 
 
 
Net (loss) income
$
(29,446
)
 
$
10,642

 
$
(50,880
)
 
$
7,071

 
 
 
 
 
 
 
 
(Loss) income per common share:
 
 
 
 
 
 
 
  Basic
$
(1.30
)
 
$
0.47

 
$
(2.24
)
 
$
0.31

  Diluted
$
(1.30
)
 
$
0.47

 
$
(2.24
)
 
$
0.31


For the 13 and 26 weeks ended July 30, 2016, 14,000 unvested shares of restricted stock were excluded from the computation of diluted earnings per share due to the anti-dilutive effect of the unvested shares.

NOTE 11—EQUITY

Stock-Based Compensation
Four million shares of the Company's common stock are reserved for issuance under the Company's Amended and Restated 2012 Stock Plan (the "Plan").

A total of 89,221 shares of restricted stock were granted under the Plan in 2013 (the "2013 Grants") to a group of eligible individuals (as defined in the Plan) and 14,000 shares of restricted stock were granted under the Plan to an eligible individual in 2015 (the "2015 Grant"). As of May 16, 2016, 52,691 shares of restricted stock comprising the 2013 Grants had been forfeited. On that date the remaining 36,530 shares of restricted stock comprising the 2013 Grants vested in accordance with the terms and conditions of the governing restricted-stock agreements and the Plan. The 14,000 shares of restricted stock comprising the 2015 Grant were forfeited in the first quarter of 2017.

In 2015 the Company granted a total of 159,475 stock units under the Plan to a group of eligible individuals, all of whom were employees of the Company at the time of the grants. As of July 29, 201734,091 stock units had been forfeited. The remaining 125,384 stock units will vest, if at all, on April 13, 2018 in accordance with and subject to the terms and conditions of governing stock-unit agreements, including forfeiture conditions, and the Plan. The fair value of these awards will vary based on changes in our stock price at each reporting period.

During the first quarter of 2017 the Company granted a total of 222,788 stock units under the Plan to a group of eligible individuals, all of whom were employees of the Company at the time of the grants. As of July 29, 2017, 33,333 of these stock units had been forfeited. The remaining 189,455 stock units will vest, if at all, in three substantially equal installments on January 30 in 2018, 2019, and 2020 in accordance with and subject to the terms and conditions of governing stock unit agreements, including forfeiture conditions, and the Plan.


15

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


The shares of restricted stock referred to above in this Note 11 constituted outstanding shares of the Company's common stock. The recipients of the restricted stock grants had full voting and dividend rights with respect to, but were unable to transfer or pledge, their shares of restricted stock prior to the applicable vesting dates. The stock units referred to above in this Note 11, which are payable solely in cash based on the Nasdaq closing price of our common stock at the applicable vesting dates, do not constitute outstanding shares of the Company's common stock. The recipients of the stock unit grants have, with respect to their stock units, no rights to receive the Company's common stock or other securities of the Company, no rights as a stockholder of the Company, no dividend rights, and no voting rights.

We are authorized to grant stock options and to make other awards (in addition to restricted stock and stock units) to eligible participants pursuant to the Plan. The Company has made no stock-option awards under the Plan. Except for the grants of restricted stock and stock units referred to above in this Note 11, the Company has not made any grant or award under the Plan. We do not currently have a broad-based program that provides for awards under the Plan on an annual basis.

We account for stock-based compensation using the fair value method in accordance with accounting standards regarding share-based payment transactions. During the 26 weeks ended July 29, 2017, we recorded $0.1 million in total compensation income for 314,839 stock units. At July 29, 2017 we had $0.8 million in total unrecognized compensation cost related to the remaining unvested stock units, which we expect to recognize over the next approximately 2.5 years.

Changes during 2017 with respect to the 2015 Grant are noted below.
 
 
26 Weeks Ended July 29, 2017
(Shares in Thousands)
 
Shares
 
Weighted-Average Fair Value Per Share on Date of Grant
Balance at January 28, 2017
 
14

 
$
9.38

Granted
 

 

Vested
 

 

Forfeited
 
(14
)
 
9.38

Balance at July 29, 2017
 

 
$


Share Repurchase Program

During 2013 the Company's Board of Directors authorized a $25 million repurchase program for the Company's outstanding shares of common stock. The timing and amount of repurchases depend on various factors, including market conditions, the Company's capital position and internal cash generation, and other factors. The Company's repurchase program does not include specific price targets, may be executed through open-market, privately negotiated, and other transactions that may be available, and may include utilization of Rule 10b5-1 plans. The repurchase program does not obligate the Company to repurchase any dollar amount, or any number of shares, of common stock. The repurchase program does not have a termination date, and the Company may suspend or terminate the repurchase program at any time. See Note 7 to these Condensed Consolidated Financial Statements regarding the Senior ABL Facility's limits on SHO’s ability to repurchase its common stock. Shares that are repurchased by the Company pursuant to the repurchase program will be retired and resume the status of authorized and unissued shares of common stock.
No shares were repurchased during the 13 and 26 weeks ended July 29, 2017. At July 29, 2017, we had approximately $12.5 million of remaining authorization under the repurchase program.

16

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


NOTE 12—STORE CLOSING CHARGES

Closed Store Charges

We continue to take proactive steps to make the best use of capital by closing unprofitable stores. The Company closed 70 and 79 Hometown store locations during the 13 and 26 weeks ended July 29, 2017, respectively. In addition, the Company closed 11 and 12 Outlet store locations during the 13 and 26 weeks ended July 29, 2017, respectively.

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

Store closing costs for the 13 and 26 weeks ended July 29, 2017 were as follows:

Thousands
Lease Termination Costs (1)
 
Inventory Related (1)
 
Impairment and Accelerated Depreciation (2)
 
Other Charges (3)
 
Total Store Closing Costs
13 weeks ended July 29, 2017
$
9,397

 
$
1,796

 
$
979

 
$
386

 
$
12,558


Thousands
Lease Termination Costs (1)
 
Inventory Related (1)
 
Impairment and Accelerated Depreciation (2)
 
Other Charges (3)
 
Total Store Closing Costs
26 weeks ended July 29, 2017
$
8,447

 
$
1,796

 
$
979

 
$
386

 
$
11,608

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


Closed Store Reserve

Store closing reserves at July 29, 2017 and January 28, 2017 are shown in the table below. Store closing reserves of $17.0 million,$0.8 million, and $7.7 million are included within other current liabilities in the Condensed Consolidated Balance Sheets at July 29, 2017, July 30, 2016 and January 28, 2017, respectively.
Thousands
 
Total
Balance at January 28, 2017
 
$
7,659

Store closing benefit
 
(950
)
Payments/utilization
 
(2,490
)
Balance at April 29, 2017
 
$
11,878

Store closing costs
 
9,783

Payments/utilization
 
(4,629
)
Balance at July 29, 2017
 
$
17,032









17

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and notes contained in this Quarterly Report on Form 10-Q and the Consolidated Financial Statements and notes contained in our Annual Report on Form 10-K for the fiscal year ended January 28, 2017 (the "2016 10-K"). This discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. See “Cautionary Statements Regarding Forward-Looking and Other Information” in this Quarterly Report on Form 10-Q and "Item 1A. Risk Factors" in the 2016 10-K for discussions of the uncertainties and the risks to which forward-looking statements are subject.
Executive Overview
We are a national retailer primarily focused on selling home appliances, lawn and garden equipment, and tools. As of July 29, 2017, we or our dealers and franchisees operated a total of 932 stores across all 50 states, Puerto Rico, and Bermuda. During the second quarter of 2017, the Company opened one store, closed 81 stores, and reacquired the franchise rights for 15 stores.
In addition to merchandise, we provide our customers with access to a suite of services, including home delivery, installation, and extended service contracts as well as access to financing through credit card and leasing programs made available by unaffiliated providers.

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

As of July 29, 2017 Hometown consisted of 795 stores as follows:

731 Sears Hometown Stores—Primarily independently operated stores, predominantly located in smaller communities and offering appliances, lawn and garden equipment, and hardware. Most of our Sears Hometown Stores carry Kenmore, Craftsman, and DieHard brand products as well as a wide assortment of other national brand products.
25 Sears Hardware Stores—Stores that carry Craftsman brand tools and lawn and garden equipment, DieHard brand batteries, and a wide assortment of other national brands and other home improvement products along with a selection of Kenmore and other national brands of home appliances.
39 Sears Home Appliance Showrooms—Stores that have a simple, primarily appliance showroom design that are positioned in metropolitan areas.
As of July 29, 2017, Hometown consisted of 727 dealer-operated stores, 36 franchisee-operated stores, and 32 Company-operated stores. The Company requires all dealer and franchisee-operated stores to operate according to the Company’s standards to protect and enhance the quality of its brands. These stores must display the required merchandise, offer all required products and services, and use the Company’s point-of-sale system. Also, the Company has the right to approve advertising and promotional and marketing materials and imposes certain advertising requirements. The Company owns the merchandise offered for sale by all dealer and franchisee-operated stores, establishes all selling prices for the merchandise, and bears general inventory risk (with specific exceptions) until sale of the merchandise and if the customer returns the merchandise. In addition, because each transaction is recorded in the Company’s point-of-sale system, the Company bears customer credit risk. The Company establishes a commission structure for stores operated by our dealers and franchisees and pays commissions to them when they sell the Company's merchandise and provide services.
As of July 29, 2017, 22 of the Company's 137 Outlet stores were operated by franchisees.
Dealers and franchisees exercise control over the day-to-day operations of their stores, make capital decisions regarding their stores, and exclusively make all hiring, compensation, benefits, termination, and other decisions regarding the terms and conditions of employment, and exclusively establish all employment policies, procedures, and practices with respect to employees.
Several of the primary differences between Company-operated stores and dealer or franchisee-operated stores are that (1) the Company is responsible for occupancy and payroll costs associated with Company-operated stores while dealers and franchisees are responsible for these costs for their stores, (2) the Company is responsible for all terms and conditions of employment for the employees in the Company-operated stores and its dealers and franchisees are responsible for all terms and conditions of employment for the employees in their stores, and (3) we pay commissions to our dealers and franchisees.

18

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

In the normal course of business, stores can transition from Company operated to franchisee or dealer operated, and vice-versa. Potential new stores may be identified by the Company, an existing dealer or franchisee, or a potential dealer or franchisee. If the Company identifies and develops a new store, the Company will generally seek to transfer that store to a dealer or a franchisee unless the store is an Outlet store, which the Company would currently intend to keep as a Company-operated store. When a dealer or a franchisee ceases to operate a store, the Company may take over its operation, generally on an interim basis, until the Company can transfer the store to another dealer or franchisee. At any given time the Company is generally operating a number of stores that are in transition from one dealer or franchisee to another dealer or franchisee. Transition stores are not included in our count of Company-operated stores due to the expected short-term nature of transition operation.
The Company's transfer of a Company-operated store to a franchisee historically has (1) in most instances increased the Company's gross margin primarily due to decreased occupancy costs and (2) increased the Company's selling and administrative expense primarily due to increased commission payments, offset partially by lower payroll and benefits expense.
Initial franchise revenues consist of franchise fees paid by franchisees with respect to new and existing Company-operated stores that we transferred to the franchisees plus the net gain or loss on related transfers of assets to the franchisees. The number of new franchised stores, the number of Company-operated stores transferred, and the net gain or loss per store transferred has been highly variable from quarter to quarter. The variation has resulted from a number of factors, including general economic conditions, which have influenced both the level of new store development and the level of interest of existing or potential franchisees in acquiring store locations, and economic factors specific to our major product categories, such as appliances. Each of these factors has impacted the expected financial returns to the Company from new store development, which in turn has impacted the number of Company-operated stores that the Company has decided from time to time to make available for transfer to franchisees. Beginning in the second quarter of 2015 the Company indefinitely suspended its franchising of additional stores except to existing Company franchisees. The suspension continued through the second quarter of 2017 and is continuing. We did not franchise any additional stores in the second quarter of 2017 or 2016 and, as a result, we did not realize any initial franchise revenues, which include the net gain or loss on related transfers of assets to franchisees, during those quarters.
Amendments to Agreements with Sears Holdings

During May 2016 the Company and Sears Holdings executed and delivered to each other amendments to most of the SHO-Sears Holdings Agreements including an amendment to our Merchandising Agreement with Sears Holdings (the "Merchandising Amendment"). The Merchandising Amendment provided that (a) SHO would pay Sears Holdings $0.6 million and SHO waived claims against Sears Holdings relating to product repair claims and (b) Sears Holdings waived claims against SHO relating to alleged KCD warranty fee underpayments and other IT and service-order transfer related claims. The net benefit to SHO of the Merchandising Amendment was $2.8 million, which amount (the "Merchandising Net Benefit") we recorded in the first quarter of 2016 as a reduction to cost of sales and occupancy expenses. For additional information regarding these amendments to the SHO-Sears Holdings Agreements see the Company's Current Reports on Form 8-K filed with the Securities and Exchange Commission on May 17, 2016 and March 9, 2017 (File No. 001-35641).

Shared Vendor Funds
In accordance with our Amended and Restated Merchandising Agreement with Sears Holdings, SHO receives from Sears Holdings specified portions of merchandise subsidies collected by Sears Holdings from its merchandise vendors and specified portions of cash discounts earned by Sears Holdings as a result of its early payment of merchandise-vendor payables (together "Vendor Funds"). During the second quarter of 2017 Sears Holdings' Vendor Funds were higher compared to the second quarter of 2016 and SHO's portion of the collected Vendor Funds during the second quarter of 2017 year were approximately $3.7 million higher than its portion for the second quarter of 2016. We cannot provide any assurance that SHO's portion of Vendor Funds collected by Sears Holdings will not decline, stay the same, or continue to increase, and if SHO's portion of Vendor Funds collected by Sears Holdings were to decline, SHO's results of operations could be adversely affected to a material extent.

Home Office Overhead Allocation

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


19

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Seasonality

Our business is not concentrated in the holiday season, as the majority of the products we sell are not typically thought of as holiday gifts. Lawn and Garden sales generally peak in our second quarter as customers prepare for and execute outdoor projects during the spring and early summer. See Note 10 to the Consolidated Financial Statements included in the 2016 10-K for our quarterly financial results (unaudited) for 2016.
Results of Operations
The following table sets forth items derived from our consolidated results of operations for the 13 and 26 weeks ended July 29, 2017 and July 30, 2016.
 
 
13 Weeks Ended
 
26 Weeks Ended
Thousands
 
July 29, 2017
 
July 30, 2016
 
July 29, 2017
 
July 30, 2016
NET SALES
 
$
489,985

 
$
556,388

 
$
938,218

 
$
1,093,369

COSTS AND EXPENSES
 
 
 
 
 
 
 
 
Cost of sales and occupancy
 
397,637

 
441,508

 
752,115

 
862,298

Selling and administrative
 
115,208

 
118,808

 
226,089

 
236,800

Selling and administrative expense as a percentage of net sales
 
23.5
%
 
21.4
%
 
24.1
%
 
21.7
%
Depreciation and amortization
 
4,704

 
3,293

 
6,908

 
6,550

Gain on the sale of assets
 

 
(25,269
)
 

 
(25,269
)
Total costs and expenses
 
517,549

 
538,340

 
985,112

 
1,080,379

Operating (loss) income
 
(27,564
)
 
18,048

 
(46,894
)
 
12,990

Interest expense
 
(1,874
)
 
(886
)
 
(3,465
)
 
(1,652
)
Other income
 
231

 
378

 
550

 
775

(Loss) income before income taxes
 
(29,207
)
 
17,540

 
(49,809
)
 
12,113

Income tax expense
 
(239
)
 
(6,898
)
 
(1,071
)
 
(5,042
)
NET (LOSS) INCOME
 
$
(29,446
)
 
$
10,642

 
$
(50,880
)
 
$
7,071

 
 
 
 
 
 
 
 
 
Gross Margin
 
$
92,348

 
$
114,880

 
$
186,103

 
$
231,071

Margin rate
 
18.8
%
 
20.6
%
 
19.8
%
 
21.1
%
Comparable Store Sales

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

Net (Loss) Income
We recorded a net loss of $29.4 million for the second quarter of 2017 compared to net income of $10.6 million for the prior-year comparable quarter. The increase in our net loss was primarily attributable to the factors discussed below in this Item 2. Income tax expense of $0.2 million and $6.9 million were recorded in the second quarters of 2017 and 2016, respectively. The effective tax expense rate was (0.8)% in the second quarter of 2017 and 39.3% in the second quarter of 2016.


20

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Adjusted EBITDA

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

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

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

The Company has undertaken an initiative on a limited number of occasions to accelerate the closing of under-performing stores in an effort to improve profitability and make the most productive use of capital. Under-performing stores are typically closed during the normal course of business at the termination of a lease or expiration of a franchise or dealer agreement and, as a result, do not have significant future lease, severance, or other non-recurring store-closing costs. When we close a significant number of stores or close them on an accelerated basis (closing prior to termination or expiration), the Company excludes the associated costs of the closings from adjusted EBITDA. In the second quarter of 2017, we excluded $11.6 million of costs associated with the accelerated closure of 81 stores. An additional $1.0 million of costs related to the accelerated closings is included in depreciation and amortization expense.

The following table presents a reconciliation of adjusted EBITDA to net income (loss), the most comparable GAAP measure, for each of the periods indicated:
 
 
13 Weeks Ended
 
26 Weeks Ended
Thousands
 
July 29, 2017
 
July 30, 2016
 
July 29, 2017
 
July 30, 2016
Net (loss) income
 
$
(29,446
)
 
$
10,642

 
$
(50,880
)
 
$
7,071

Income tax expense
 
239

 
6,898

 
1,071

 
5,042

Other income
 
(231
)
 
(378
)
 
(550
)
 
(775
)
Interest expense
 
1,874

 
886

 
3,465

 
1,652

Operating (loss) income
 
(27,564
)
 
18,048

 
(46,894
)
 
12,990

Depreciation and amortization
 
4,704

 
3,293

 
6,908

 
6,550

Gain on the sale of assets
 

 
(25,269
)
 

 
(25,269
)
Provision for franchisee note losses, net of recoveries
 
5,585

 
(251
)
 
5,701

 
(283
)
IT transformation investments
 
8,463

 
3,323

 
17,718

 
6,473

Accelerated closure of under-performing stores
 
11,579

 

 
10,629

 

Adjusted EBITDA
 
$
2,767

 
$
(856
)
 
$
(5,938
)
 
$
461



21

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

13-Week Period Ended July 29, 2017 Compared to the 13-Week Period Ended July 30, 2016
Net Sales

Net sales in the second quarter of 2017 decreased $66.4 million to $490.0 million, or 11.9%, from the second quarter of 2016. This decrease was driven primarily by the impact of closed stores (net of new store openings) and a 2.1% decrease in comparable store sales. Comparable store sales were down 0.9% and 5.0% in Hometown and Outlet, respectively. The lawn and garden category outperformed the average comparable store sales, home appliances and tools underperformed the average, and mattresses performed at the average.

Gross Margin

Gross margin was $92.3 million, or 18.8% of net sales, in the second quarter of 2017 compared to $114.9 million, or 20.6% of net sales, in the second quarter of 2016. The decrease in gross margin rate was primarily driven by $11.2 million of store closing costs partially offset by a $1.7 million physical inventory gain in Outlet. The combined impact of store closing costs and shrink on the gross margin rate was a reduction of 233 basis points in the second quarter of 2017 and a reduction of 32 basis points in the second quarter of 2016.

Selling and Administrative Expenses

Selling and administrative expenses decreased to $115.2 million, or 23.5% of net sales, in the second quarter of 2017 from $118.8 million, or 21.4% of net sales, in the prior-year comparable quarter. The decrease was primarily due to lower expenses from stores closed (net of new store openings) since the third quarter of 2016 and lower commissions paid to dealers and franchisees on lower sales volume. The reductions were partially offset by higher IT transformation investments and charges of $5.6 million related to the write-off of, and additional reserves taken on, franchisee notes receivable in the second quarter of 2017. IT transformation investments were $8.5 million, or 1.7% of sales, in the second quarter of 2017 compared to $3.3 million, or 0.6% of sales, in the second quarter of 2016. Excluding the impact of the higher IT transformation investments and the charge related to franchisee notes receivable, selling and administrative expenses as a percent of sales were unchanged.

Gain on Sale of Assets

During the second quarter of 2016, we completed the sale of an owned property located in San Leandro, California. Net proceeds from the sale were $26.1 million, and we recorded a gain on the sale of $25.3 million.

Operating (Loss) Income

We recorded an operating loss of $27.6 million during the second quarter of 2017 compared to operating income of $18.0 million during the second quarter of 2016, which period included the $25.3 million gain on sale of assets. The decrease in operating income was also due to lower volume and a lower gross margin rate partially offset by a decrease in selling and administrative expenses.
Income Taxes
Income tax expense of $0.2 million and $6.9 million were recorded in the second quarters of 2017 and 2016, respectively. The effective tax rate was (0.8)% in the second quarter of 2017 and 39.3% in the second quarter of 2016.
Net (Loss) Income
We recorded a net loss of $29.4 million for the second quarter of 2017 compared to a net income of $10.6 million for the prior-year comparable quarter. The increase in our net loss was primarily attributable to the factors discussed above.



22

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

26-Week Period Ended July 29, 2017 Compared to the 26-Week Period Ended July 30, 2016
Net Sales

Net sales in the first two quarters of 2017 decreased $155.2 million to $938.2 million, or 14.2%, from the first two quarters of 2016. This decrease was driven primarily by the impact of closed stores (net of new store openings) and a 5.3% decrease in comparable store sales. Comparable store sales were down 4.6% and 6.8% in Hometown and Outlet, respectively. The lawn and garden category outperformed the average comparable store sales, mattresses performed at the average, home appliances performed slightly below the average, and tools underperformed the average.

Gross Margin

Gross margin was $186.1 million, or 19.8% of net sales, in the first two quarters of 2017 compared to $231.1 million, or 21.1% of net sales, in the first two quarters of 2016. The decrease in gross margin rate was primarily driven by $10.2 million of store closing costs and lower margin on merchandise sales partially offset by favorability in Outlet shrink. The combined impact of store closing costs and shrink on the gross margin rate was a reduction of 134 basis points in the second quarter of 2017 and a reduction of 66 basis points in the second quarter of 2016.

Selling and Administrative Expenses

Selling and administrative expenses decreased to $226.1 million, or 24.1% of net sales, in the first two quarters of 2017 from $236.8 million, or 21.7% of net sales, in the prior-year comparable period. The decrease was primarily due to lower expenses from closed stores (net of new store openings), lower commissions paid to dealers and franchisees on lower sales volume, and lower marketing costs. These decreases were partially offset by higher IT transformation investments, charges of $5.7 million taken in 2017 related to the write-off of, and additional reserves taken on, franchisee notes receivable, and higher payroll and benefits. IT transformation investments were $17.7 million, or 1.9% of sales, in the first two quarters of 2017 compared to $6.5 million, or 0.6% of sales, in the first two quarters of 2016.

Gain on Sale of Assets

During the second quarter of 2016, we completed the sale of an owned property located in San Leandro, California. Net proceeds from the sale were $26.1 million, and we recorded a gain on the sale of $25.3 million.

Operating (Loss) Income

We recorded an operating loss of $46.9 million for the first two quarters of 2017 compared to operating income of $13.0 million for the comparable period in 2016, which period included the $25.3 million gain on sale of assets. The decrease in operating income in the first two quarters of 2017 was also due to lower volume and a lower gross margin rate partially offset by a decrease in selling and administrative expenses.
Income Taxes
Income tax expense of $1.1 million and $5.0 million were recorded in the first two quarters of 2017 and 2016, respectively. The effective tax rate was (2.2)% in the first two quarters of 2017 and 41.6% in the first two quarters of 2016.
Net (Loss) Income
We recorded a net loss of $50.9 million for the first two quarters of 2017 compared to net income of $7.1 million for the prior-year comparable period. The decrease in our net income was primarily attributable to the factors discussed above.


23

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Business Segment Results
Hometown
Hometown results and key statistics were as follows:
 
13 Weeks Ended
 
26 Weeks Ended
Thousands, except for number of stores
July 29, 2017
 
July 30, 2016
 
July 29, 2017
 
July 30, 2016
NET SALES
$
347,640

 
$
396,614

 
$
644,854

 
$
763,193

Comparable store sales %
(0.9
)%
 
(6.5
)%
 
(4.6
)%
 
(4.6
)%
COSTS AND EXPENSES
 
 
 
 
 
 
 
Cost of sales and occupancy
280,126

 
313,231

 
510,000

 
597,369

Selling and administrative
75,759

 
83,554

 
150,176

 
164,407

Selling and administrative expense as a percentage of net sales
21.8
 %
 
21.1
 %
 
23.3
 %
 
21.5
 %
Depreciation and amortization
1,890

 
1,507

 
2,745

 
3,076

Total costs and expenses
357,775

 
398,292

 
662,921

 
764,852

Operating loss
$
(10,135
)
 
$
(1,678
)
 
$
(18,067
)
 
$
(1,659
)
 
 
 
 
 
 
 
 
Gross margin dollars
67,514

 
83,383

 
134,854

 
165,824

Margin rate
19.4
 %
 
21.0
 %
 
20.9
 %
 
21.7
 %
 
 
 
 
 
 
 
 
Total Hometown stores
 
 
 
 
795

 
964

13-Week Period ended July 29, 2017 Compared to the 13-Week Period Ended July 30, 2016.
Net Sales

Hometown net sales in the second quarter of 2017 decreased $49.0 million to $347.6 million, or 12.3%, from the second quarter of 2016. The decrease was primarily due to the impact of closed stores (net of new stores) and a 0.9% decrease in comparable store sales. The home appliance, lawn and garden, and tools categories improved their performance compared to the first quarter.
Gross Margin

Gross margin was $67.5 million, or 19.4% of net sales, in the second quarter of 2017 compared to $83.4 million, or 21.0% of net sales, in the second quarter of 2016. The decrease in gross margin rate was primarily driven by $4.1 million of store closing costs and lower margin on merchandise sales partially offset by lower occupancy costs. The combined impact of occupancy costs and store closing costs on the gross margin rate was 229 basis points in the second quarter of 2017 and 159 basis points in the second quarter of 2016.
Selling and Administrative Expenses

Selling and administrative expenses decreased to $75.8 million, or 21.8% of net sales, in the second quarter of 2017 from $83.6 million, or 21.1% of net sales, in the prior-year comparable quarter. The decrease was primarily due to lower expenses from store closures (net of new store openings), lower marketing costs, and lower commissions paid to dealers and franchisees on lower sales volume. These decreases were partially offset by higher IT transformation investments, which were $5.6 million, or 1.6% of sales, in the second quarter of 2017 compared to $2.2 million, or 0.6%, of sales, in the second quarter of 2016.



24

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Operating Loss

We recorded operating losses of $10.1 million and $1.7 million in the second quarters of 2017 and 2016, respectively. The increase in operating losses was primarily due to lower volume and a lower gross margin rate partially offset by favorability in selling and administrative expenses.
26-Week Period ended July 29, 2017 Compared to the 26-Week Period Ended July 30, 2016.
Net Sales

Hometown net sales in the first two quarters of 2017 decreased $118.3 million to $644.9 million, or 15.5%, from the first two quarters of 2016. The decrease was primarily due to the impact of closed stores (net of new stores) and a 4.6% comparable store sales decrease. The home appliances category outperformed the average comparable store sales. Lawn and garden, tools and mattresses categories underperformed the average comparable stores sales.
Gross Margin

Gross margin was $134.9 million, or 20.9% of net sales, for the first two quarters of 2017, compared to $165.8 million, or 21.7% of net sales, for the first two quarters of 2016. The decrease in gross margin rate was primarily driven by lower margin on merchandise sales and $3.1 million of store closing costs partially offset by lower occupancy costs. The combined impact of occupancy costs and store closing costs on the gross margin rate was 179 basis points in the first two quarters of 2017 and 170 basis points in the first two quarters of 2016.
Selling and Administrative Expenses

Selling and administrative expenses decreased to $150.2 million, or 23.3% of net sales, in the first two quarters of 2017 from $164.4 million, or 21.5% of net sales, in the prior-year comparable period. The decrease was primarily due to lower expenses due to store closures (net of new store openings), lower commissions paid to dealers and franchisees on lower sales volume, and lower marketing expense. These decreases were partially offset by higher IT transformation investments. IT transformation investments were $11.8 million, or 1.8% of sales, in the first two quarters of 2017 compared to $4.3 million, or 0.6% of sales, in the first two quarters of 2016.
Operating Loss

We recorded operating losses of $18.1 million and $1.7 million in the first two quarters of 2017 and 2016, respectively. The increase in operating loss was primarily due to lower volume and a lower gross margin rate partially offset by favorability in selling and administrative expenses.




25

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Outlet
Outlet results and key statistics were as follows:
 
 
13 Weeks Ended
 
26 Weeks Ended
Thousands, except for number of stores
 
July 29, 2017
 
July 30, 2016
 
July 29, 2017
 
July 30, 2016
NET SALES
 
$
142,345

 
$
159,774

 
$
293,364

 
$
330,176

Comparable store sales %
 
(5.0
)%
 
(0.5
)%
 
(6.8
)%
 
(1.9
)%
COSTS AND EXPENSES
 
 
 
 
 
 
 
 
Cost of sales and occupancy
 
117,511

 
128,277

 
242,115

 
264,929

Selling and administrative
 
39,449

 
35,254

 
75,913

 
72,393

Selling and administrative expense as a percentage of net sales
 
27.7
 %
 
22.1
 %
 
25.9
 %
 
21.9
 %
Depreciation and amortization
 
2,814

 
1,786

 
4,163

 
3,474

Gain on the sale of assets
 

 
(25,269
)
 

 
(25,269
)
Total costs and expenses
 
159,774

 
140,048

 
322,191

 
315,527

Operating (loss) income
 
$
(17,429
)
 
$
19,726

 
$
(28,827
)
 
$
14,649

 
 
 
 
 
 
 
 
 
Gross margin dollars
 
24,834

 
31,497

 
51,249

 
65,247

Margin rate
 
17.4
 %
 
19.7
 %
 
17.5
 %
 
19.8
 %
 
 
 
 
 
 
 
 
 
Total Outlet stores
 
 
 
 
 
137

 
159

13-Week Period ended July 29, 2017 Compared to the 13-Week Period Ended July 30, 2016
Net Sales

Outlet net sales in the second quarter of 2017 decreased $17.4 million to $142.3 million, or 10.9%, from the second quarter of 2016. This decrease was driven primarily by the impact of closed stores (net of new store openings) and a 5.0% decrease in comparable store sales. Home appliances performed slightly below the average comparable store sales. The lawn and garden, tools, and apparel categories underperformed the average comparable store sales, while furniture and mattresses outperformed the average.
Gross Margin

Gross margin was $24.8 million, or 17.4% of net sales, in the second quarter of 2017 compared to $31.5 million, or 19.7% of net sales, in the second quarter of 2016. The decrease in gross margin rate was primarily due to $7.1 million of store closing costs and flat occupancy costs on lower sales. These declines were partially offset by higher margin on merchandise sales and a $1.7 million physical inventory gain. The combined impact of occupancy costs, store closing costs, and shrink on the gross margin rate was 1,368 basis points in the second quarter of 2017 and 870 basis points in the second quarter of 2016.
Selling and Administrative Expenses
Selling and administrative expenses increased to $39.4 million, or 27.7% of net sales, in the second quarter of 2017 from $35.3 million, or 22.1% of net sales, in the prior-year comparable quarter. The increase was primarily due to charges of $5.6 million related to the write-off of, and additional reserves taken on, franchisee notes receivables, higher IT transformation investments, and higher payroll and benefits. These increases were partially offset by lower commissions paid to franchisees on lower volume and lower expenses from stores closed (net of new store openings) since the second quarter of 2016. IT transformation investments were $2.8 million, or 2.0% of sales, in the second quarter of 2017 compared to $1.1 million, or 0.7% of sales in the second quarter of 2016.

26

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Gain on Sale of Assets

During the second quarter of 2016, we completed the sale of an owned property located in San Leandro, California. Net proceeds from the sale were $26.1 million, and we recorded a gain on the sale of $25.3 million.

Operating (Loss) Income

We recorded an operating loss of $17.4 million in the second quarter of 2017 and operating income of $19.7 million in the second quarter of 2016, which period included the $25.3 million gain on sale of assets. The decrease in operating income was also due to a lower gross margin rate, lower volume, and an increase in selling and administrative expenses.
26-Week Period ended July 29, 2017 Compared to the 26-Week Period Ended July 30, 2016
Net Sales

Outlet net sales decreased $36.8 million, or 11.1%, to $293.4 million in the first two quarters of 2017 from $330.2 million in the first two quarters of 2016. The decrease was primarily due to a 6.8% comparable store sales decrease and the impact of closed stores (net of new store openings). The furniture, mattresses, and lawn and garden categories outperformed the average comparable store sales while home appliances, tools, and apparel underperformed the average.
Gross Margin

Gross margin was $51.2 million, or 17.5% of net sales, in the first two quarters of 2017 compared to $65.2 million, or 19.8% of net sales, in the first two quarters of 2016. The decrease in gross margin rate was primarily driven by $7.1 million of store closing costs, flat occupancy costs on lower sales, and $2.4 million received from the Merchandising Net Benefit in 2016. These declines were partially offset by lower shrink ($1.7 million physical inventory gain in the second quarter of 2017 and a $3.4 million physical inventory charge in the first quarter of 2016), and lower distribution and repair center costs. The combined impact of store closing costs, occupancy costs, shrink, and the Merchandising Net Benefit reduced the gross margin rate 1,142 basis points in the first two quarters of 2017 compared to a reduction of 872 basis points in the first two quarters of 2016.
Selling and Administrative Expenses

Selling and administrative expenses increased to $75.9 million, or 25.9% of net sales, in the first two quarters of 2017 from $72.4 million, or 21.9% of net sales, in the prior-year comparable period. The increase was primarily due to charges of $5.7 million related to the write-off of, and additional reserves taken on, franchisee notes receivable in 2017, increased IT transformation investments ($5.9 million in the first two quarters of 2017 compared to $2.2 million in the first two quarters of 2016) and higher payroll and benefits expenses. These increases were partially offset by lower commissions paid to franchisees on lower volume and lower expenses from closed stores (net of new store openings).
Gain on Sale of Assets
During the second quarter of 2016, we completed the sale of an owned property located in San Leandro, California. Net proceeds from the sale were $26.1 million, and we recorded a gain on the sale of $25.3 million.

Operating (Loss) Income

We recorded an operated loss of $28.8 million in the first two quarter of 2017 and operating income of $14.6 million in the first two quarters of 2016, which period included the $25.3 million gain on sale of assets. The increase in operating loss was also due to a lower gross margin rate, lower volume, and an increase in selling and administrative expenses.

27

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Analysis of Financial Condition
Cash and Cash Equivalents
We had cash and cash equivalents of $18.3 million as of July 29, 2017, $14.1 million as of January 28, 2017, and $18.7 million as of July 30, 2016.
For the first two quarters of 2017 we funded ongoing operations with cash provided by financing activities. Our primary needs for liquidity are to fund inventory purchases, IT transformation investments, capital expenditures and for general corporate purposes.

Cash Flows from Operating Activities
Cash used in operating activities was $76.7 million as compared to $21.2 million for the 26 weeks ended July 29, 2017 and July 30, 2016, respectively. The decrease in operating cash flow was primarily due to the net loss of $50.9 million for the 26 weeks ended July 29, 2017 as compared to net income of $7.1 million for the same period of 2016 and a decrease in payables to Sears Holdings of approximately $56.0 million resulting from a reduction in merchandise receipts and accelerated payment terms in exchange for early-payment discounts. The impact of these differences was partially offset by a decrease in merchandise inventories of approximately $16.9 million during the first and second quarter of 2017.

Total merchandise inventories were $356.9 million at July 29, 2017, $427.2 million at July 30, 2016 and $373.8 million at January 28, 2017. Merchandise inventories declined $53.5 and $16.8 million in Hometown and Outlet, respectively, from July 30, 2016. The decrease in Hometown was primarily due to store closures. Outlet's decrease was primarily driven by store closures, lower home appliances receipts, and a furniture assortment transition partially offset by higher lawn and garden inventory resulting from opportunistic buys.

We obtain our merchandise through agreements with subsidiaries of Sears Holdings and with other vendors. Merchandise acquired from subsidiaries of Sears Holdings (including Kenmore, Craftsman, DieHard, and other merchandise) accounted for approximately 81% and 78% of total purchases of all inventory from all vendors for the 26 weeks ended July 29, 2017 and July 30, 2016, respectively. The loss of, or a material reduction in the amount of, merchandise made available to us by Sears Holdings could have a material adverse effect on our business and results of operations. See also "Cautionary Statements Regarding Forward-Looking and Other Information" in this Quarterly Report on Form 10-Q.

In addition, our merchandise-vendor arrangements generally are not long-term (except for our Amended and Restated Merchandising Agreement with Sears Holdings) and none of them guarantees the availability of merchandise inventory in the future. Our growth strategy depends to a significant extent on the willingness and ability of our vendors to supply us with sufficient merchandise inventory. As a result, our success depends, in part, on maintaining or improving relationships with existing vendors to seek to ensure continuity of merchandise inventory and on developing relationships with new vendors, especially with respect to merchandise inventory to be sold by Outlet. If we fail to maintain or improve our relations with our existing vendors or fail to maintain the quality of merchandise inventory they supply us, or if we cannot maintain or acquire new vendors of favored brand-name merchandise inventory, and if we cannot acquire new vendors of merchandise inventory to be sold by Outlet, our ability to obtain a sufficient amount and variety of merchandise at acceptable prices may be limited, which could have a negative impact on our business and could materially affect our results of operations, financial condition, liquidity, and cash flows. In addition, merchandise inventory acquired from alternative sources, if any, may be of a lesser quality and more expensive than the merchandise inventory that we currently purchase.
Cash Flows from Investing Activities
Cash used in investing activities was $4.6 million for the 26 weeks ended July 29, 2017 compared to cash provided by investing activities of $19.2 million for the 26 weeks ended July 30, 2016. Cash provided by investing activities for the first two quarters of 2016 included an asset sale of $26.1 million, which did not recur during the first two quarters of 2017.
Cash Flows from Financing Activities
Cash provided by financing activities was $85.5 million for the 26 weeks ended July 29, 2017 compared to $2.4 million during the 26 weeks ended July 30, 2016. The increase of $83.1 million was primarily due to an increase of $85.6 million in net borrowings under the Senior ABL Facility in 2017 compared to a $2.1 million increase in net borrowings under the Prior Facility in 2016.


28

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Financing Arrangements

In October 2012 the Company entered into a Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent, which provided (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the “Prior Facility”). Under the Prior Facility the Company initially borrowed $100 million which was used to pay a cash dividend to Sears Holdings prior to the Separation.

On November 1, 2016 the Company’s three operating subsidiaries, Sears Authorized Hometown Stores, LLC, Sears Home Appliance Showrooms, LLC, and Sears Outlet Stores, L.L.C., and the Company, entered into an Amended and Restated Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent and collateral agent, which provides (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the “Senior ABL Facility”). The Senior ABL Facility, which amended and restated the Prior Facility in its entirety, provides for extended revolving credit commitments in an aggregate amount equal to $170 million (the “Extended Revolving Credit Commitments”) and non-extended revolving credit commitments in an aggregate amount equal to $80 million (the “Non-Extended Revolving Credit Commitments”). The Extended Revolving Credit Commitments will mature on the earlier of (1) February 29, 2020 and (2) six months prior to the expiration of specified agreements entered into with Sears Holdings and its subsidiaries in connection with the Separation (the “Subject Agreements”) unless they are extended to a date later than February 29, 2020 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility. The Non-Extended Revolving Credit Commitments will mature on the earlier of (1) October 11, 2017 and (2) six months prior to the expiration of the Subject Agreements unless they are extended to a date later than October 11, 2017 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility. Costs related to and incurred for the November 1, 2016 refinancing totaled approximately $5.4 million, of which $4.4 million is remaining and is included in Prepaid and Other current assets on the Consolidated Balance Sheet as of July 29, 2017 and is being amortized over the remaining term of the Senior ABL Facility.

As of July 29, 2017 we had $112.4 million outstanding under the Senior ABL Facility, which approximated the fair value of these borrowings. Up to $75 million of the Senior ABL Facility is available for the issuance of letters of credit and up to $25 million is available for swingline loans. The Senior ABL Facility permits us to request commitment increases in an aggregate principal amount of up to $100 million. Availability under the Senior ABL Facility as of July 29, 2017 was $86.8 million, with $6.1 million of letters of credit outstanding under the facility. If the Non-Extended Revolving Credit Commitments had matured prior to the end of the second quarter of 2017, our availability under the Senior ABL Facility would have been approximately $52 million as of July 29, 2017.

In the first quarter of 2017, we resumed our agreement with Sears Holdings whereby SHO paid Sears Holdings' invoices for merchandise and services on accelerated terms in exchange for a 37 to 43-basis-point cash discount that depends on the number of days we pay invoices before their 10-day due dates. Senior ABL Facility borrowings increased by approximately $23 million as of July 29, 2017, as a result of our accelerated payments. The discounts we received for the accelerated payments totaled $1.4 million and $2.0 million for the 13 and 26 weeks ended July 29, 2017, respectively. We can, in our sole discretion, revert to ten-day, no-discount payment terms at any time.

The principal terms of the Senior ABL Facility are summarized below.

Prepayments

The Senior ABL Facility is subject to mandatory prepayment in amounts equal to the amount by which the outstanding extensions of credit exceed the lesser of the borrowing base and the commitments then in effect.

Security and Guarantees

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


29

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Interest; Fees

The interest rates per annum applicable to the loans under the Senior ABL Facility are based on a fluctuating rate of interest measured by reference to, at the Company’s election, either (1) an adjusted London inter-bank offered rate (LIBOR) plus a borrowing margin ranging from (x) 3.50% to 4.50%, in the case of the Extended Revolving Credit Commitments or (y) 2.00% to 2.50%, in the case of the Non-Extended Revolving Credit Commitments (which the blended rate was approximately 4.52% at July 29, 2017), and in each case based on availability under the Senior ABL Facility, or (2) an alternate base rate plus a borrowing margin, ranging from (x) 2.50% to 3.50%, in the case of the Extended Revolving Credit Commitments or (y) 1.00% to 1.50%, in the case of the Non-Extended Revolving Credit Commitments (which the blended rate was approximately 6.52% at July 29, 2017), and in each case based on availability under the Senior ABL Facility.

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

Covenants

The Senior ABL Facility includes a number of negative covenants that, among other things, limit or restrict the ability of the Company and its subsidiaries (including the guarantors) to, subject to certain exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make prepayments on other indebtedness, and engage in mergers or change the nature of the business of the Company and its subsidiaries (including the guarantors). In addition, upon excess availability falling below a specified level, the Company is required to comply with a minimum fixed charge coverage ratio. The Senior ABL Facility also limits SHO’s ability to declare and pay cash dividends and repurchase its common stock. The Senior ABL Facility would not have permitted us to pay cash dividends or to repurchase our common stock as of July 29, 2017.

The Senior ABL Facility also contains affirmative covenants, including financial and other reporting requirements. As of July 29, 2017, SHO was in compliance with all covenants under the Senior ABL Facility.

Events of Default

The Senior ABL Facility includes customary and other events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments, change of control, failure to perform a “Material Contract” (which includes specified SHO-Sears Holdings Agreements) to the extent required to maintain it in full force and effect, the failure to enforce a Material Contract in accordance with its terms, or Sears Holdings terminates specified “Separation Agreements” (which include specified SHO-Sears Holdings Agreements).

Uses and Sources of Liquidity
As of July 29, 2017, we had cash and cash equivalents of $18.3 million. The adequacy of our available funds will depend on many factors, including the macroeconomic environment and the operating performance of our stores. We believe that our existing cash and cash equivalents, cash flows from our operating activities, and, to the extent necessary, availability under the Senior ABL Facility will be sufficient to meet our anticipated liquidity needs for at least the next 12 months.
Capital lease obligations as of July 29, 2017 and July 30, 2016 were $0.4 million and $0.8 million, respectively.
Off-Balance Sheet Arrangements
As of July 29, 2017, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of the Securities and Exchange Commission's Regulation S-K.

30

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

Recent Accounting Pronouncements
See Part I, Item 1, “Financial Statements—Notes to Condensed Consolidated Financial Statements— Note 1 — Recent Accounting Pronouncements,” for information regarding new accounting pronouncements.
Business Process Outsourcing and Information Systems
We have entered into a Master Services Agreement with Capgemini U.S. LLC in which Capgemini agrees to provide business process outsourcing services and services for the migration of the current information technology systems and processes provided by Sears Holdings to new, state-of-art business and technology infrastructure and systems primarily provided by NetSuite Inc. (collectively, the “BPO”). We expect the new infrastructure and systems will provide greater strategic and operational flexibility, provide better control of our systems and processes, reduce our total cost of information-system ownership over the term of the Master Services Agreement, and reduce some of the risks inherent in our services relationship with, and reduce our dependence on, Sears Holdings.

Our plan and expectation is that the new infrastructure and systems will be operational in all material respects by the end of 2017.  The new infrastructure and systems will enable us, and we currently intend, to replace many of the corporate services provided by Sears Holdings with services provided by Capgemini, other third-party providers, and, on a limited basis, internally by SHO.  The replaced services could include tax, accounting, non-merchandise procurement, risk management and insurance, advertising and marketing, human resources, loss prevention, environmental, product and human safety, facilities, information technology, online, payment clearing, and other financial, real estate management, merchandising, and other support services.

We continue to incur additional corporate expenses in 2017 as a result of the BPO.  Selling and administrative expenses related to the BPO were $17.7 million and $6.5 million in the first two quarters of 2017 and 2016, respectively.

The migration to the new infrastructure and systems involves significant risks for us, which we have summarized in Item 1A, "Risk Factors," in the 2016 10-K. These risks could have a material adverse effect on our business and results of operations.

CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING AND OTHER INFORMATION
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "forward-looking statements"). Statements preceded or followed by, or that otherwise include, the words "believes," "expects," "anticipates," "intends," "project," "estimates," "plans," "forecast," "is likely to," and similar expressions or future or conditional verbs such as "will," "may," "would," "should," and "could" are generally forward-looking in nature and not historical facts. The forward-looking statements are subject to significant risks and uncertainties that may cause our actual results, performance, and achievements in the future to be materially different from the future results, future performance, and future achievements expressed or implied by the forward-looking statements. The forward-looking statements include, without limitation, information concerning our future financial performance, business strategies, plans, goals, beliefs, expectations, and objectives. The forward-looking statements are based upon the current beliefs and expectations of our management.
The following factors, among others, (1) could cause our actual results, performance, and achievements to differ materially from those expressed in the forward-looking statements, and one or more of the differences could have a material adverse effect on our ability to operate our business and (2) could have a material adverse effect on our results of operations, financial condition, liquidity, and cash flows: if Sears Holdings seeks the protection of the U.S. bankruptcy laws (including the effects of the imposition of the "automatic stay" and the effects if Sears Holdings were to seek to reject one or more of the SHO-Sears Holdings Agreements); our ability to offer merchandise and services that our customers want, including those under the KCD Marks; our Amended and Restated Merchandising Agreement with Sears Holdings provides that (1) if a third party that is not an affiliate of Sears Holdings acquires the rights to one or more (but less than all) of the KCD Marks Sears Holdings may terminate our rights to buy merchandise branded with any of the acquired KCD Marks and (2) if a third party that is not an affiliate of Sears Holdings acquires the rights to all of the KCD Marks Sears Holdings may terminate the Amended and Restated Merchandising Agreement in its entirety, over which events we have no control; the sale by Sears Holdings and its subsidiaries to other retailers that compete with us of major home appliances and other products branded with one of the KCD Marks; on May 26, 2016 Sears Holdings announced that it would explore alternatives for its Kenmore, Craftsman, and Diehard businesses and further expand the presence of these brands and on August 25, 2016 Sears Holdings announced that it was continuing to explore alternatives for these businesses by evaluating potential partnerships or other transactions; on March 9, 2017 Sears Holdings announced that it had completed its sale to Stanley Black & Decker, Inc. of Sears Holdings's Craftsman business (the "Stanley Purchase"), including the Craftsman brand name and related intellectual property rights (Sears Holdings has waived its right in the Amended and Restated Merchandising Agreement

31

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

to terminate, as a result of the Stanley Purchase, the Company's rights to buy from Sears Holdings merchandise branded with the Craftsman brand); the willingness and ability of Sears Holdings to fulfill its contractual obligations to us; on July 20, 2017 Sears Holdings announced the launch of Kenmore products on Amazon.com and that Sears Holdings planned to expand the full line of Kenmore home appliances available on Amazon.com; on August 22, 2017 Sears Holdings announced licensing agreements with third parties to manufacture and distribute Kenmore floor care products and DieHard batteries and flashlights; our ability to successfully manage our inventory levels and implement initiatives to improve inventory management and other capabilities; competitive conditions in the retail industry; worldwide economic conditions and business uncertainty, the availability of consumer and commercial credit, changes in consumer confidence, tastes, preferences and spending, and changes in vendor relationships; the fact that our past performance generally, as reflected on our historical financial statements, may not be indicative of our future performance as a result of, among other things, the consolidation of Hometown and Outlet into a single business entity, the Separation, and operating as a standalone business entity; the impact of increased costs due to a decrease in our purchasing power following the Separation, and other losses of benefits associated with having been wholly owned by Sears Holdings and its subsidiaries prior to the Separation; our continuing reliance on Sears Holdings for most products and services that are important to the successful operation of our business, and our potential need to rely on Sears Holdings for some products and services beyond the expiration, or earlier termination by Sears Holdings, of our agreements with Sears Holdings; the willingness of Sears Holdings' appliance, lawn and garden, tools, and other vendors to continue to supply to Sears Holdings on terms (including vendor-payment terms for Sears Holdings' merchandise purchases) that are acceptable to it (which vendor-payment terms, we believe, are becoming, and in the future could continue to become, increasingly uneconomic for Sears Holdings) and to us, merchandise that we would need to purchase from Sears Holdings to ensure continuity of merchandise supplies for our businesses; the willingness of Sears Holdings’ appliance, lawn and garden, tools, and other vendors to continue to pay to Sears Holdings merchandise-related subsidies and allowances and cash discounts (some of which Sears Holdings is obligated to pay to us); our ability to resolve, on commercially reasonable terms, future disputes with Sears Holdings regarding the material terms and conditions of our agreements with Sears Holdings; our ability to establish information, merchandising, logistics, and other systems separate from Sears Holdings that would be necessary to ensure continuity of merchandise supplies and services for our businesses if vendors were to reduce, or cease, their merchandise sales to Sears Holdings or provide logistics and other services to Sears Holdings or if Sears Holdings were to reduce, or cease, its merchandise sales to us or reduce providing, or cease to provide, logistics and other services to us; if Sears Holdings' sales of major appliances and lawn and garden merchandise to its retail customers decline Sears Holdings' sales to us of outlet-value merchandise could decline; our ability to maintain an effective and productive business relationship with Sears Holdings, particularly if future disputes were to arise with respect to the terms and conditions of our agreements with Sears Holdings; most of our agreements related to the Separation and our continuing relationship with Sears Holdings were negotiated while we were a subsidiary of Sears Holdings (except for amendments agreed to after the Separation), and we may have received different terms from unaffiliated third parties (including with respect to merchandise-vendor and service-provider indemnification and defense for negligence claims and claims arising out of failure to comply with contractual obligations); our reliance on Sears Holdings to provide computer systems to process transactions with our customers (including the point-of-sale system for the stores we operate and the stores that our independent dealers and independent franchisees operate, which point-of-sale system captures, among other things, credit-card information supplied by our customers) and others, quantify our results of operations, and manage our business ("SHO's SHC-Supplied Systems"); SHO's SHC-Supplied Systems could be subject to disruptions and data/security breaches (Sears Holdings announced on May 31, 2017 that its Kmart store payment-data systems had been infected with a malicious code and that the code had been removed and the event contained), and Sears Holdings could be unwilling or unable to indemnify and defend us against third-party claims and other losses resulting from such disruptions and data/security breaches, which could have one or more material adverse effects on SHO; our ability to implement the BPO in accordance with our plans, expectations, current timetable, and anticipated cost; limitations and restrictions in the Senior ABL Facility and related agreements governing our indebtedness and our ability to service our indebtedness; competitors could continue to reduce their promotional pricing on new-in-box appliances, which could continue to adversely impact our sales of out-of-box appliances and associated margin; our ability to generate profitable sales of merchandise and services on our transactional ecommerce websites in the amounts we have planned to generate; our ability to obtain additional financing on acceptable terms; our dependence on the ability and willingness of our independent dealers and independent franchisees to operate their stores profitably and in a manner consistent with our concepts and standards; our ability to sell profitably online all of our merchandise and services; our dependence on sources outside the U.S. for significant amounts of our merchandise inventories; fixed-asset impairment for long-lived assets; our ability to attract, motivate, and retain key executives and other employees; our ability to maintain effective internal controls as a publicly held company; our ability to realize the benefits that we expect to achieve from the Separation; litigation and regulatory trends challenging various aspects of the franchisor-franchisee relationship could expand to challenge or adversely affect our relationships with our independent dealers and independent franchisees; low trading volume of our common stock due to limited liquidity or a lack of analyst coverage; and the impact on our common stock and our overall performance as a result of our principal stockholder's ability to exert control over us.

32

SEARS HOMETOWN AND OUTLET STORES, INC.
13 and 26 Weeks Ended July 29, 2017 and July 30, 2016

The foregoing factors should not be understood as exhaustive and should be read in conjunction with the other cautionary statements, including the "Risk Factors," that are included in this Quarterly Report on Form 10-Q and in the 2016 10-K and in our other filings with the Securities and Exchange Commission and our other public announcements. While we believe that our forecasts and assumptions are reasonable, we caution that actual results may differ materially. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we projected. Consequently, actual events and results may vary significantly from those included in or contemplated or implied by our forward-looking statements. The forward-looking statements included in this Quarterly Report on Form 10-Q are made only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to publicly update or review any forward-looking statement made by us or on our behalf, whether as a result of new information, future developments, subsequent events or circumstances, or otherwise, except as required by law.

33


Item 3. Quantitative and Qualitative Disclosures about Market Risk
We are subject to interest rate risk associated with the Senior ABL Facility, which requires us to pay interest on outstanding borrowings at variable rates. Assuming the Senior ABL Facility were fully drawn in principal amount equal to $250 million, each one percentage point change in interest rates payable with respect to the Senior ABL Facility would result in a $2.5 million change in annual cash interest expense with respect to the Senior ABL Facility.
Item 4. Controls and Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the 26 weeks ended July 29, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION

Item 1. Legal Proceedings
As of the date of this Quarterly Report on Form 10-Q we are not party to any litigation that we consider material to our operations.
Notwithstanding the above, from time to time we are, and will continue to be, subject to various legal claims, including those alleging wage and hour violations, payroll violations, employment discrimination, unlawful employment practices, Americans with Disabilities Act claims, Family and Medical Leave Act claims, product liability claims as a result of the sale of merchandise and services, claims with respect to franchise and dealer transactions, relationships, operations, and terminations as well as various legal and governmental proceedings. Some of these claims from time to time include, and will continue to include, class or collective-action allegations, and the proceedings for some of these claims are, and will continue to be, in jurisdictions with reputations for aggressive application of laws and procedures against corporate defendants. Litigation is inherently unpredictable. Each proceeding, claim, and regulatory action against us, whether meritorious or not, could be time consuming, result in significant legal expenses, require significant amounts of management time, result in the diversion of significant operational resources, require changes in our methods of doing business that could be costly to implement, reduce our net sales, increase our expenses, require us to make substantial payments to settle claims or satisfy judgments, require us to cease conducting certain operations or offering certain products in certain areas or generally, and otherwise harm our business, results of operations, financial condition, and cash flows, perhaps materially. See also "Cautionary Statements Regarding Forward-Looking and Other Information” and "Risk Factors" in this Quarterly Report on Form 10-Q.

Item 1A. Risk Factors

There have been no material changes from the risk factors previously disclosed in the 2016 10-K, which risks should be carefully considered. Those risks could materially affect our results of operations, financial condition, liquidity, and cash flows. Those risks are not exclusive, and additional risks to which we are subject include, but are not limited to, the statements in “Cautionary Statements Regarding Forward-Looking and Other Information,” and the risks to our businesses described elsewhere, in this Quarterly Report on Form 10-Q.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
During 2013 the Company's Board of Directors authorized a $25 million repurchase program for the Company's outstanding shares of common stock. The timing and amount of repurchases depend on various factors, including market conditions, the Company's capital position and internal cash generation, and other factors. The Company's repurchase program does not include specific price targets, may be executed through open-market, privately negotiated, and other transactions that may be available, and may include utilization of Rule 10b5-1 plans. The repurchase program does not obligate the Company to repurchase any dollar amount, or any number of shares, of common stock. The repurchase program does not have a termination date, and the Company may suspend or terminate the repurchase program at any time.

34


Shares that are repurchased by the Company pursuant to the repurchase program will be retired and will resume the status of authorized and unissued shares of common stock.
The Company did not repurchase any shares during the 26 weeks ended July 29, 2017. As of July 29, 2017 we had approximately $12.5 million of remaining authorization under the repurchase program. The Senior ABL Facility limits SHO’s ability to repurchase its common stock. See "Management's Discussion and Analysis-Analysis of Financial Condition-Financing Arrangements" in this Quarterly Report on Form 10-Q.

Item 6. Exhibits
The Exhibits listed in the accompanying “Exhibit Index” have been filed as part of this Quarterly Report on Form 10-Q.


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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
Sears Hometown and Outlet Stores, Inc.
 
 
By:
 
/S/ E. J. BIRD
Name:
 
E. J. Bird
Title:
 
Senior Vice President and Chief Financial Officer
(Principal Financial Officer
and Principal Accounting Officer)
 
Date:
 
September 5, 2017


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SEARS HOMETOWN AND OUTLET STORES, INC.
EXHIBIT INDEX


 
 
Exhibit Number
Exhibit Description
3.1

3.2

3.3


10.1(1)
10.2(1)
10.3(1)(2)
10.4(1)
10.5
.
 
31.1(1)
31.2(1)
32(1)
101(3)
The following financial information from the Quarterly Report on Form 10-Q for the fiscal quarter ended July 29, 2017, formatted in XBRL (eXtensible Business Reporting Language) and furnished electronically herewith: (i) the Condensed Consolidated Statements of Operations (Unaudited) for the 13 and 26 Weeks Ended July 29, 2017 and July 30, 2016; (ii) the Condensed Consolidated Balance Sheets (Unaudited) at July 29, 2017, July 30, 2016, and January 28, 2017; (iii) the Condensed Consolidated Statements of Cash Flows (Unaudited) for the 26 Weeks Ended July 29, 2017 and July 30, 2016; (iv) the Condensed Combined Statements of Stockholders' Equity (Unaudited) for the 26 Weeks Ended July 29, 2017 and July 30, 2016; and (v) the Notes to the Condensed Consolidated Financial Statements (Unaudited).


(1) Filed herewith.
(2) Specified terms of this Exhibit have been omitted and separately filed by the registrant with the Securities and Exchange Commission pursuant to the registrant's request for confidential treatment.
(3) Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

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