Hudson Bay (HBC), the Canadian listed diversified global
retailer has come under attack from activist investor, Land and Building
Investment Management (L&B). L&B says that HBC, ostensibly a retailer, is
in reality a real estate company and should behave like one. The gist of
L&B’s thesis is that HBC’s real estate is worth a lot more if put to the
right use; but HBC’s management, by focusing on its retail business, is
fighting a losing battle.
There is some merit to L&B’s miff - HBC’s share price
has fallen over 51% in 2 years, from a high of C$28.40 in mid-June 2015 to the
current C$11.12. Over this period, HBC has expanded its retail operations into
Europe through a major acquisition and increased store count by almost 50%. The
expansion in retail operations has coincided with the tanking share price.
L&B
has laid out its case in two letters to HBC. L&B says that HBC’s
management needs to focus on unlocking value from its core real estate
portfolio instead of throwing good money in the losing retail business. HBC’s own
valuation (backed by lenders and in part by investment from savvy JV partners)
shows its core real estate portfolio being worth C$35 per share net of debt. This
is over 3 times its current share price. Having read L&B’s two letters, I
was reminded of two classic scenes from the movie ‘Other People’s Money’ – the first where Danny De
Vito’s corporate raider (“Larry the Liquidator”) enthusiastically explains to
the management of New England Wire & Cable Company that its hidden assets
are worth 2.5x its current share price; and the second where Danny De
Vito’s character argues his case in front of the shareholders of New England
Wire & Cable.
HBC’s real estate
Unlike most traditional retail operations, HBC owns majority
of the real estate occupied by its various retail banners. And this is a
quality real estate portfolio in good locations which can be put to alternate
use. This gives HBC an edge – even if its retail operations tank, it still has
option value in its real estate portfolio. But HBC’s shares currently trade at
~70% discount to HBC’s C$35 per share real estate value. This implies that
either the market has failed to acknowledge the value inherent in HBC’s real
estate portfolio, or that the market thinks HBC will continue to burn cash in a
losing retail battle, with the traditional brick & mortar model in
secular decline, never being able to unlock the value in its real estate.
The table below
summarises HBC’s real estate value
Below, I have calculated per share value of HBC’s real
estate portfolio for various Cap Rate and NOI scenarios. As can be seen, NOI's
need to fall by ~40% to justify the current share price.
A point worth noting here is that HBC has debt attached to its retail business, per my calculation, this was C$12 per share at the end of 1st Quarter 2017. Even assigning nil value to HBC’s retail operation and assuming that the debt of ~C$12 a share in its retail business eats into the value of HBC’s real estate, gives a net equity value per share for HBC’s real estate portfolio of C$ 22.33 (or 2x current share price).
Value unlock
potential for HBC’s real estate
HBC’s 100% owned estate in 611 5th Avenue (the Saks
Fifth Avenue Store) and 424 5th Avenue (Lord & Taylor store) are
alone worth ~C$18 a share (net of debt). Both of these stores are in fantastic
locations near the Rockefeller Center in Manhattan, one of the most sought
after real estate in New York. As L&B points out in its letter, there is no
reason why this estate cannot be put to better alternate use and be more
valuable – e.g. as a mix of retail, commercial and residential units or even as
a hotel or an office block.
The rest of HBC’s core real estate is in two JVs where HBC
is the majority partner along with savvy real estate players - Simon Property
Group and the Canadian REIT, RioCan. HBC’s share of equity value in the two
JV’s add up to C$17 a share.
Given the quality of HBC’s estate, there must be a number of
different ways in which value can be unlocked. There is no reason why HBC needs
to tie its estate down to its retail banners, particularly if they can be put
to more valuable alternate use.
The big danger is if HBC’s retail operations end up sinking
the value of its real estate.
HBC’s retail business
HBC’s retail portfolio includes ten
different retail banners operating in formats ranging from luxury to premium
department stores to off price fashion stores. It has more than 480 stores and
over 66,000 employees across North America and Europe. In one of its recent
investor presentations, it sees itself as a global aggregator in the retail
sector, with acquisitions being a big play.
But like for most traditional brick
& mortar retailers, things have not been rosy for HBC.
Falling Sales: Comparable sales growth, which
measures sales growth in stabilised stores, has been negative over the last
three quarters, averaging a negative 3.8% each quarter. Even before the
negative trend, comparable sales growth had started falling drastically for a
couple of quarters.
Falling profitability: With falling sales comes fall in
profitability. To calculate the profitability of HBC’s retail operations, I
have backed out the estimated cash rents paid to 3rd parties, to
HBC’s two JVs and the implied cash rents on HBC’s NY 5th Avenue
estates.
As can be seen in the table above, if the current trend in comparable sales decline continues, I expect HBC’s retail operations to be in negative EBITDA territory over the next twelve months and for FY18. HBC recently announced a major restructuring plan in its retail operation to generate C$350m in annual cost savings from FY18 onwards, and even assuming the plan succeeds in generating the estimated savings, I expect the retail business to be in negative EBITDA territory in FY18 unless comparable store sales decline is not arrested.
Ambitious but imprudent Capex plan given current situation: HBC
intends to spend C$1 – 1.12 billion in gross capex for FY17 with net capex
spend after landlord incentives estimated at C$450 – 550 million. Initiatives
include opening 31 new stores across the company’s various banners and a major
refurbishment of its Saks 5th Avenue estate. When comparable store
sales are tanking as it is, the proposed capex initiatives may be a cash burn with
no return. In addition, the company continues to tout itself as a major
aggregator in the retail space via acquisitions, further increasing the risk of
cash burn.
Pressure on cash flow and debt: The falling comparable store
sales and profitability, combined with an ambitious capex and store expansion
plan doesn’t bode well for free cash flows.
The real danger, if the company continues in its current
path and its retail sales and profitability continue to decline, is that
shareholders realise no value from its real estate portfolio. Based on my
estimates HBC could burn through ~C$450 - C$500 million in cash per annum
(particularly if it continues with its growth capex spend) resulting in the net
debt attached to its retail operations continuing to grow and ultimately eating
away at the value attached to its real estate. For example, net debt in its
operating business was C$1.5 billion at the end of FY16 (or C$8.2 per share);
at the end of 1st Qtr 2017 this number had increased to C$2.3
billion (or C$12 per share); and if cash burn continues without any improvement
in retail sales or profitability, net debt attached to HBC’s operations could
hit C$3.6 billion at the end of FY18 (or C$ 20 per share).
The risk is that cash burn and increasing debt load attached
to the retail operations will eat away at whatever value the company can
salvage from its real estate, particularly if the management continues in its
current spending path with no reversal in sales and profitability trend.
Go forward scenarios
In my opinion, one of the following scenarios could play out
at HBC:
- One scenario is that the company decides to play ball (or is left
with no option but to) with the activist, implementing L&B’s asks. This
will mean monetizing its NY 5th Avenue real estate by putting it to
alternate use, exiting from Europe by selling its operations and/or real estate
there, monetising its real estate JV interests, reducing its growth capex and retail
expansion plans and considering a management led buyout (management currently own
~20% of the company). This scenario has the potential to generate in excess of
2x return on current share price.
- The other scenario is where the company
continues in its current path, with a focus on its retail banners; comparable store
sales continue to falter and retail burns through cash, increasing net debt. With
no sight of a plan to unlock value, the market will continue to punish the
share price. Such a scenario will not be sustainable for long and the board
will need to reconsider L&B’s ask eventually. However, in this scenario,
the path to unlocking value will be prolonged and painful.
Clearly, for this situation to work in the favour of the
shareholders, time and execution is of the essence. In particular, HBC cannot
continue burning cash and adding debt for too long trying to turn around its
retail business. HBC’s Canadian retail business is valuable, but its US and
European banners are a drag. The sooner
HBC realises this, the better for shareholders.
At current share price, and given the activist’ involvement,
the probability of shareholders realising a 2x return over the next 3 – 5 years
look decent. Market’s significant discount to underlying real estate value
implies a worst case scenario; L&B’s involvement and HBC’s quality real
estate portfolio should protect shareholders from the worst case.
