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Crafting a Deal in Order to Stay Afloat

Sears is in trouble.  Or rather, it’s been in trouble for some time.  Same-store sales fell 13% in November and December 2016 and Sears has booked losses of over $9 billion during the past eight years.  The company has had to resort to shedding assets – tangible and intangible – in a bid to right-size operations and manage liquidity.  In the past, Sears financed some of these losses through the sale of real estate.  In addition to closing 150 low-performing Sears and Kmart stores, Sears recently received financing of $500 million through loans backed by its real estate.  In January 2017, Sears announced the sale of its Craftsman brand to Stanley Black & Decker.  The Kenmore and DieHard brands are reportedly next on the chopping block.

Sears acquired the Craftsman brand in 1927 for $500, and the brand has been a key part of its operations since.  In the 1940s, the brand became popular for its line of power tools.  Approximately 90% of Craftsman products are currently sold through Sears-related stores, and the balance of the brand sales come through Ace Hardware and Costco.  Approximately 35% of Craftsman’s sales are tools (both power and hand), about 40% of sales are lawn and garden equipment, and 20% are storage and garage related.

Stanley Black & Decker will pay $525 million when the transaction closes and an additional $250 million at the end of the third year after closing.  Sears will also collect a percentage of incremental non-Sears Craftsman revenue for 15 years following closing.  The rate will be 2.5% through 2020, 3.0% through January 2023, and 3.5% until the end of the 15 year period.  Stanley estimates that the net present value of these payments is approximately $900 million.    Stanley has stated that the deal exposes it to no credit risk from Sears, aiming to protect itself from any future bankruptcy proceeding.  The transaction has been approved by the boards of both companies and is expected to close in 2017.

As part of the deal, Stanley will grant a license – royalty-free for the first 15 years – to Sears to continue selling Craftsman-branded products.  At the end of the 15 year period, Sears will be required to pay a royalty rate of 3.0% on sales of Craftsman products.  Craftsman sales outside of Sears-related stores were approximately $200 million during the last twelve months.  Stanley expects to achieve incremental non-Sears Craftsman sales growth of $100 million per year for ten years.

Given the large percentage of Sears-related sales and significant non-Sears growth assumptions underlying the transaction, Craftsman is a risky purchase for Stanley Black & Decker.  The markets appeared to view the transaction as a net positive for Stanley – stock price rose 1.6% following the announcement, from $116.48 to $118.35.  Stanley has stated that it expects the deal to increase earnings per share by up to $0.80 by year ten (excluding deal costs).

The markets remain skeptical of Sear’s prospects.  Following the announcement of the deal on January 5, Sears stock price was essentially unchanged.  However, by January 13, the price had fallen to $8.74, a decrease of 16% from the pre-announcement price of $10.36.  Despite the deal and the recent cash infusion, Sears remains in tricky financial waters.

So, what are the takeaways from the perspective of valuation analysts?  Assuming a 5% annual sales growth (mid-point of mid-point of Stanley’s organic growth assumption [click here to view call transcript about the transaction] range or similar lines of business) beyond year 10, the discount rate assumption underlying the estimated $900 million transaction value is approximately 8.5%.  While operating margins in the first few years from Craftsman sales is likely to be in the low teens, Stanley management expects the product line will eventually generate margins similar to its tools and storage segment, currently just north of 17%.  Accordingly, the 3% royalty rate Stanley hopes to charge Sears over the longer term represents a profit split of slightly less than a fifth.  Of course, actual Sears margins (and expectations) could differ from Stanley assumptions.

On a more conceptual note, the transaction illustrates the value of strong brands even apart from a storied corporate umbrella.  Companies are born and companies die, but some brands (can) live on.

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