Hudson Bay: Activist play

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 1^st 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 5^th Avenue (the Saks Fifth Avenue Store) and 424 5^th 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 3^rd parties, to HBC’s two JVs and the implied cash rents on HBC’s NY 5^th 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 5^th 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 1^st 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 5^th 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.