February 25, 2016
To Our Shareholders, Associates and Members:
2015 has proven to be the year where the impact of the changes I have described to you in the past, has spread more broadly to retailers that had previously proven to be relatively immune to such shifts. Walmart (WMT, Financial), Nordstrom (JWN, Financial), Macy’s (M, Financial), Staples (SPLS, Financial), Whole Foods (WFM, Financial) and many others have felt the impact of disruptive changes from online competition and new business models.
These shifts also are affecting companies that influence where people purchase products and the specific products they choose, like Google and Facebook (FB), as well as companies that deliver products to customers, like UPS (UPS) and FedEx (FDX), not to mention newer companies such as Uber and Instacart. And even companies like Yahoo! (YHOO) and Twitter (TWTR) are being challenged to evolve or to face dissatisfied users and shareholders, leading to major corporate actions.
In the retail sector alone, we have seen a variety of responses to these tectonic shifts. Some of them include mergers (Office Depot/Office Max/Staples, Walgreens/Rite Aid), joint ventures structured as acquisitions (CVS/Target Pharmacy), market exits (Target Canada, Tesco’s Fresh and Easy), sale of companies (Safeway, Saks), bankruptcies (Radio Shack, Wet Seal, America Apparel), in-store partnerships and leasing (Finish Line/Macy’s, Best Buy/Macy’s, Sephora/JCPenney) and geographic expansion (Primark US). Each of these alternatives carries opportunities and risks, but collectively they signal how large the impact and pace of change has been, with no signs that it will abate any time soon. They also highlight how the skill sets of the leadership of retail companies need to evolve to include more sophistication around technology, business models and adaptability.
2015 in review
Today we announced our fourth quarter and full year 2015 results. Since the earnings release and supplemental materials include significant financial details, I will be more qualitative in my comments in this letter. If you would like more specific information, I encourage you to refer to the earnings materials available here.
After five consecutive quarters of improving performance* from the third quarter of 2014 through the third quarter of 2015, we were unable to overcome the impact of milder than normal weather throughout the U.S. in November and December and experienced disappointing results in our fourth quarter. The weather conditions had a cascading effect on many retailers, leading to reduced spending and heavy discounting on winter clothing and related items. Reports from other department store companies such as Macy’s, Kohl’s and Nordstrom and specialty apparel retailers such asÂ Ralph LaurenÂ (RL, Financial), GapÂ (GAP, Financial) and J. Crew highlighted the difficult environment for apparel retail in the fourth quarter of 2015.
While the weather conditions magnified our apparel problems in the fourth quarter, our apparel business nevertheless needs significant improvement. The operating leverage in our apparel business is significant – it can change our profitability meaningfully if we manage the business differently. As a result, improving our apparel business will be a priority for the leadership team in 2016.
2015 was more positive for us in other areas. For example, we continue to be the leader in Home Appliances and complete solutions for homeowners. In 2015, we successfully launched our Kenmore PRO Appliance Suite, a new premium line of appliances that gives homes an elevated look without the need for costly remodels. Developed with aspiring home chefs in mind, Kenmore PRO appliances provide a beautiful professional kitchen design and luxury performance at an affordable price. Despite speculation and reports to the contrary, we continue to enjoy strong partnerships with our vendors. For example, we have negotiated contracts for our Kenmore appliance brand across all three major suppliers that guarantee supply of Kenmore products through the end of 2018.
Many businesses are now experiencing the realities that we have recognized and have been addressing for years. From a real estate standpoint, they, too, are significantly reducing the size and number of stores they operate and starting to look for partners that can use their space more effectively while also increasing traffic into the remaining store space. We have seen significant retail company stock price declines during the past year, even from companies that others have long admired for their relative competitive advantages.
In 2015, Sears (SHLD, Financial) and Kmart completed a significant step in the redeployment of our real estate assets. In July, we completed a Real Estate Investment Trust (REIT) transaction, which created Seritage Growth Properties (SRG, Financial). Currently, Seritage owns 255 properties that are leased to Sears Holdings. Almost all of these properties are operated by either Sears or Kmart, and many lease space to third-party retailers like Whole Foods and Primark. These third-party retailers have driven new traffic and customers to our properties and we expect future tenants will have an even greater impact.
Progress toward our transformation
Sears Holdings remains focused on its two core strategic initiatives: Shop Your Way membership and Integrated Retail. While our Sears and Kmart stores still drive the vast majority of our sales, a significant amount of my time is spent on transforming Sears Holdings into a company whose primary goal is to serve its members and help them manage their lives. Our focus builds on Sears and Kmart’s decades-long legacy of helping families while also recognizing that our mission today and in the future is to serve people directly through knowing them better as individuals and as families and personalizing information and experiences that are most relevant to them.
Shop Your WayÂ
Our Shop Your Way membership program continues to evolve. When it was started in late 2009, it was predominantly store-based and it looked and felt like just another traditional loyalty program. Over time, Shop Your Way’s capabilities have grown, first focused on creating an engaging desktop experience and then translating those features into an innovative mobile experience. The capabilities we have developed are engaging, fun, rewarding and useful for our members as they navigate their daily lives, whether it is buying, researching, sharing or looking for inspiration.
Shop Your Way partners. We are expanding our product selection to more brands, expanding our Shop Your Way network to include more partners and expanding our experience to more members. We also have launched digital experiences dedicated to driving awareness of, and transactions with, our partners and affiliates. As Shop Your Way builds partnerships, we are continually broadening the opportunity for members to earn rewards on the products and brands they care about. Going forward, we intend to expand and deepen our relationships with third parties to make Shop Your Way the go-to rewards destination for everything from gift giving and big-ticket shopping to everyday purchases.
Increased member engagement. This past year, we saw a marked increase in member engagement with the full suite of Shop Your Way rewards and benefits. Overall, investment in Shop Your Way as a cornerstone of our member-centric transformation continues to drive material benefit to Sears Holdings. In 2015, we awarded more points to members than ever before. Through refinements in our member targeting and segmentation strategies using real-time analytic input on our members’ specific needs and shopping patterns, we continue to improve our ability to deliver the right offers to the right members at the right time while maintaining a profitable return on those issuances. Shop Your Way programs and offers have not only saved members time and money, but have also driven increased trips and larger basket sizes while contributing to the profitability of our company.
Our Shop Your Way membership remains high and engagement remains strong with our core members. That is not to say that there is no impact when we close stores or when our profitability declines. As I will explain shortly, this is where Integrated Retail plays an important role. We are not becoming solely a digital company. Integrated Retail means that our stores and our associates who work in our stores matter more than ever. And the role of the store and the activities of our people are evolving to fit the way customers in general want to shop.
On the Integrated Retail front, we continue to create new experiences that leverage our existing brick-and-mortar infrastructure while combining it with new mobile experiences and capabilities. Some of the most important recent developments include:
Meet With An Expert. We are continuing to see more and more of our members interact with us digitally, especially while researching products prior to making a purchase. Last year we introduced Meet With An Expert, a free and first-of-its-kind service that helps online shoppers considering large item purchases in Home Appliances, Mattresses or Lawn & Garden connect with in-store experts. This new shopping service is the latest in a series of integrated retail innovations we have introduced over the past several years. It combines the digital world with in-store shopping by enabling members to research products online and complete their purchase in store after they speak to a knowledgeable Sears associate.
Mobile growth. We are seeing a significant increase in engagement from our members through our mobile platform. Last year mobile’s share of Sears’ online sales increased 100 percent year-over-year. More than a third of our online traffic in 2015 came from a mobile phone, a 46% increase from the previous year. We continued to make investments in our digital capabilities and refreshed our mobile apps to enhance existing shopping conveniences as well as offer new services.
Integrated fulfillment. At Sears, our In-Vehicle Pickup, Return and Exchange services continue to be a favorite with our members. It’s a fast, highly convenient service that allows members to pick up, return or exchange their online purchases for free at any Sears store, guaranteed in five minutes or less, without ever leaving their vehicles.
Free In-Store Shipping. In addition to enhancing existing capabilities, in 2015 we introduced several new convenience features for our members, such as Free In-Store Shipping, which allows members shopping in our stores to get free shipping on orders placed through their mobile apps. It provides another easy option to purchase items that may not be available in store.
Bluelight Specials. For many of our members who grew up shopping at Kmart, the famous “Bluelight Specials” evoke childhood memories and “Attention, Kmart shoppers” is a familiar refrain. Bluelight Specials are now back by popular demand, not only in stores but also digitally through the new Kmart app.
Layaway & Go and Pay In-Store. Layaway, a service that gives our customers an option to cost effectively finance their purchases, continues to be popular among our Kmart shoppers. To make it even more convenient, we introduced Layaway & Go, another easy way for our members to manage layaways, from adding items to making weekly payments, easily through our mobile app. In addition, we introduced another payment option that gives Kmart shoppers an option to reserve items online and pay however they wish in store – through cash, check, credit card or gift card.
Connecting Online and Offline. We continue to find new ways to integrate in-store and online shopping by enhancing mobile and online technologies to create new conveniences for Shop Your Way members and customers. 74 percent of Sears online transactions are now considered Integrated Retail, meaning both digital and physical channels were involved in the fulfillment of digital orders.
Changing business models in other industries
Companies are creating new business models or adapting old ones to adjust to fundamental shifts in technology, competitive landscapes, government policies and regulations or macro trends to serve their customers in new ways. While few people may have heard of Uber five years ago, now it’s become almost a household name. It has reportedly raised over $10 billion in capital since it commenced operations at progressively higher valuations, in some cases exceeding $50 billion in value. At the same time, it was recently reported that Uber is losing over $1 billion a year in China alone. In an environment where new companies like Uber can raise almost unlimited capital, what are the implications for older companies that are held to a very different standard when it comes to profitability and regulation?
Companies like Amazon (AMZN, Financial) were able to grow rapidly without having to collect sales tax, while traditional retail companies had the dual disadvantages of having to report profits and to collect sales tax from their customers. While it is true that Amazon’s customers, by law, were required to calculate and pay sales tax in states that required it, many commentators conveniently ignored these laws in their coverage of Amazon and the state and local authorities did little to enforce the existing laws. The consequence? We are now seeing more and more retail stores shut down and the tax base of many municipalities eroding due to the hollowing out of the sales tax base as theÂ Wall Street Journal recently reported. Even the largest and most successful retailers, like Walmart, are shuttering stores all over the world.
Some innovative companies like Tesla (TSLA, Financial) are heavily subsidized by government policy (either directly or through purchases made by their customers) while existing car companies are forced to comply with mandates to produce cars that people may not want at enormous cost. These companies rely heavily on continued financing (Tesla raised over $1 billion in equity and over $2.5 billion in debt over the past four years) and favorable capital market conditions and valuations while companies viewed through a more traditional lens, like Sears Holdings, are met with skepticism even though we have an enormous asset base and a proven history of monetizing these assets and raising additional capital to fund our obligations and transformation.
Changes in retail and our transformation journey
Large companies like Sears Holdings have also been met with additional burdens like higher minimum wage costs. With stores that are marginally profitable or unprofitable, such additional cost burdens can be the straw that breaks the camel’s back, causing stores to close and eliminate jobs.
Regardless, retail remains a very large industry with as many opportunities as there are challenges. Our transformation efforts continue, albeit impacted by our poor operating results. Our ability to accelerate this change is constrained by our diminished cash flow and requires us to generate cash from asset sales, raise capital and improve our operating performance.
The good news is that we have a vast portfolio of assets and businesses to draw from. As I mentioned earlier, in 2015 we completed the rights offering of Seritage Growth Properties. This rights offering in conjunction with its associated financing raised over $2.7 billion for Sears Holdings, which enabled us to reduce debt and generate liquidity to fund our pension plan and our operating losses.
As we described in our earnings release, it is neither our goal nor our intention to use our asset value to fund continued operating losses. We are taking more aggressive actions and deeper cost cuts to restore the company to profitability and to stem the operating losses of the past several years. These decisions are difficult but necessary.
In some cases, we have been operating stores that have not made money in many years. Why? Because our goal has always been to make all of our stores profitable and not simply to liquidate them. While we have been criticized for not investing more in our stores, I have explained in the past that the investments in our transformation go well beyond our stores, but don’t ignore our stores. When we do close stores, in most cases we don’t believe that we could have saved the stores simply by spending money. We believe that our investments in the Shop Your Way membership platform and our Integrated Retail capabilities were more appropriate investments given the massive shift in how customers are shopping and how competition has evolved.
As our store base shrinks in number and in size, the level of overall investment to maintain and improve them also shrinks in size. As we learn more about how to serve our members better, the number and size of our stores will change. While I am not predicting that we will be opening new stores in the near term, it is entirely possible that we may open new, smaller stores in the future.
Overall, as we look at our performance, it’s clear that we need to accelerate our efforts. We are not going to continue to operate business as usual with negative EBITDA, and we are not going to let operating losses erode the asset value of the company. We will continue to take strong, difficult but necessary actions to reduce losses. We will have to think, work and move harder and faster. This won’t be easy, but the pace of change in the world we’re working in is constantly increasing.
Our approach to our transformation has been consistent, even as it is not without its risks. And, transformation requires retooling of internal processes and expectations, as well as rebranding external expectations and capabilities. It is necessary and we are doing it.
Because of Sears and Kmart’s longstanding history and cultural impact, we are targeted for criticism when our results are poor. But it is unfair to evaluate our approach through the rearview mirror without acknowledging the changing circumstances in our industry as well as our bold attempts to change the way we do business to meet this changing reality.
I want to thank our shareholders and other stakeholders who have supported us. We remain committed to improving our operating performance and continuing our transformation. We have been tenacious and resilient, and we will continue to adjust and adapt with the goal of becoming a company fit to serve our members in the 21st century and to compete effectively against traditional and new competitors alike.
Edward S. Lampert