Recommendation: Long the Hudson’s Bay Co Common Stock (HBC.CN, $17.50)
To see this report in its original format and to download the valuation model, please follow these links:
Investment Thesis
HBC is a multi-banner retailer whose management is actively seeking to optimize and unlock the company’s real estate value, which they are likely to do through the creation of a REIT. Of HBC’s 38.1 mm in GLA (square footage), 36% is either fee-owned (8.0 mm sq ft) or ground leased (5.5 mm sq ft). While this owned real estate percentage is not as large as other real estate monetization plays like LTM, within this portfolio are several high quality marquee properties, including the iconic Saks building on 5th Avenue in NYC, the Saks Wilshire Boulevard location in Beverly Hills, the Lord & Taylor flagship store on 5th Avenue in NYC, and Hudson’s Bay flagship stores in downtown Vancouver, Montreal and Calgary.
HBC screens as an expensive stock at 8.7x next year’s estimated EBITDA versus peers at 6.4x, however it looks significantly cheaper than peers when considering the value that they are likely to unlock from their real estate. We value the real estate at $5.2 b, or 86% of the EV of the company, implying the retail operations are trading at just 1.9x next year’s EBITDA, a 70% discount to peers. We also like HBC for its heavy insider ownership, with the CEO owning over 5% of the shares out.
The stock is worth $26 on 2015 estimates, and $30 on 2016 estimates, for 49% and 72% upside, respectively. This 2016 target equates to an IRR of 35%. The primary catalyst will be HBC’s announcement of their strategy to monetize the real estate, which management has said will happen no later than April 2015 (with the 4Q report).
Company Description
HBC is a multi-banner retailer in the US and Canada operating primarily under the Hudson’s Bay, Lord & Taylor, Saks Fifth Avenue, and Saks OFF 5th brands. The company was originally founded in 1670, and is North America’s longest continually operated company. Today’s version of HBC has been assembled through multiple acquisitions by the National Development Retail Corp, a private investment group led by Richard Baker (the current HBC Chairman and CEO). The shares are listed on the Toronto Stock Exchange and trade under the ticker symbol HBC. HBC’s stock price and earnings are denominated in Canadian dollars. Using the treasury method, the current diluted share count is 183.1 mm, and the diluted share count at our 2016 target is 189.5 mm.
Through their various brands, HBC sells an assortment of apparel, accessories, shoes, beauty and home merchandise. On a consolidated basis, HBC had 320 stores at year end 2013, which produced $7.6 b in retail sales pro forma for the Saks acquisition, with same store sales growth of 3.7% (excluding fx impacts). The breakdown of their store base was 90 Hudson’s Bay stores, 49 Lord & Taylor stores, 41 Saks Fifth Avenue stores, 71 Saks OFF 5th stores, and 69 Home Outfitters stores. As a percentage of 2013 pro forma revenue, Saks Fifth Avenue was 46% of sales, Hudson’s Bay was 31% of sales, Lord & Taylor was 19% of sales, and Home Outfitters was 4% of sales.
For those not familiar with their banners we provide a very brief description here. Hudson’s Bay Company is Canada’s largest national branded department store and one of the most recognized retail brands in Canada. Lord & Taylor is the oldest luxury specialty-retail department store chain in the U.S., and is primarily concentrated in the Northeast. Saks Fifth Avenue is one of the world’s preeminent luxury specialty retailers, and Saks Off 5th offers value-oriented merchandise. Home Outfitters is Canada’s largest kitchen, bed and bath specialty superstore. The company also has three Zellers clearance centers. The store base geographic distribution is as follows:
The Evolution of HBC
The National Retail Development Corp (NRDC), a PE group formerly led by the current HBC Chairman and CEO Richard Baker, built HBC through several transformative acquisitions and one major disposition over the last 8 years. They first acquired Lord & Taylor from Federated Department Stores in 2006 for $1.2b (
http://tinyurl.com/L-Tacquisition), then acquired control of Hudson’s Bay Company (including Zellers) in 2008 for $1.3 b in total proceeds (
http://tinyurl.com/HudsonsBayAcquisition). In 2011, taking advantage of the general lack of prime retail space available in Canada, they sold 189 of their 276 Zellers department store locations to Target for $1.8 b (
http://tinyurl.com/ZellersSale). This transaction allowed them to deleverage, to invest $500m into renovating their Hudson’s Bay and Lord & Taylor stores, and cleared the way for HBC to IPO. In 2012, Lord & Taylor and Hudson’s Bay merged into the Hudson’s Bay Company, then IPO’d on the Toronto Stock Exchange under the ticker HBC at an offering price of CAD $17.15.
In November of 2013, HBC acquired Saks Fifth Avenue for $2.9 b including debt, paying 10.5x EBITDA or 7.8x EBITDA including estimated synergies. Based on 2012 results, the transaction increased HBC’s revenue by +120% and EBITDA by 94%. The rationale for the deal was to enhance HBC’s EBITDA growth and strategic positioning, to leverage HBC’s infrastructure to bring the Saks banner to Canada, and to create the scale needed to monetize the combined owned real estate portfolio. A complete chronology of the Hudson’s Bay Company can be found here:
http://tinyurl.com/HBCchronology
Operational Trends
This idea focuses on the potential upside from HBC’s real estate monetization rather than upside to consensus estimates, and as such we only briefly cover the operational aspects of the business here. Recent operational trends at HBC could be classified as average. Comparable sales growth has consistently been in the low-to-mid-single digits, the gross margin has been consistently trending slightly lower, and the adjusted EBITDA margin has been steady in the 7-8% range. In 2013, HBC reported strong sales growth at Hudson’s Bay and Saks, with Lord & Taylor down slightly (their Northeast-centric footprint and severe winter weather were cited drivers for the slight decline). Comp sales were up 5.4% on a consolidated basis, and were up 2.8% excluding fx impacts. On a local currency basis, Hudson’s Bay comp sales were up 6.2%, Saks were up 3.1%, and Lord & Taylor was down by 0.7%.
Management is Actively Seeking to Monetize the Real Estate Portfolio
One of the most attractive aspects of this idea is that management is dedicated to and actively engaging in pursuing a monetization of HBC’s real estate assets, making it not an issue of probability but an issue of timing. On the Saks acquisition call from July 2013, HBC’s CEO stated that “the acquisition creates a high value real estate portfolio and the opportunities to pursue strategic alternatives, including potentially the creation of a real estate investment trust to unlock additional value and accelerate deleveraging.” The monetization process is ongoing, with the CEO stating on the September 2014 earnings call that they “have been diligently exploring various alternatives to potentially surface value from our real estate portfolio”, and that they “expect to be in a position to announce details of our real estate review not later than the release date of our fiscal 2014 annual financial statements.”
Also comforting is the fact that both HBC’s CEO and CFO have significant experience in monetizing real estate assets. NRDC partners, which at the time was led by HBC’s current CEO, realized a substantial financial gain when they sold 189 Zellers department store locations to Target in 2011. With that transaction, NRDC received $1.8 b in proceeds versus the $1.3 b they paid to acquire both Hudson’s Bay and Zellers just 3 years earlier. More recently, in February 2014, HBC undertook a $650 mm sale-leaseback of their Toronto flagship Hudson’s Bay store and the adjacent Simpson office tower, realizing a 4.75% cap rate on that deal (4.0% cap rate for the Hudson’s Bay flagship store, and a 7.0% cap rate for the Simpson office tower).
HBC’s recently hired CFO Paul Beesley is also very experienced in monetizing real estate through his long tenure at the Empire Company (EMP/A.CN), a Canadian food distribution business. In 2006 Paul led the creation of an Empire related REIT called the Crombie REIT (CRR-U.CN), which Empire subsequently engaged in numerous real estate transactions with over the following years.
There are many alternative routes to monetization that HBC could pursue, however comments from the CEO indicate that forming a REIT is the best and most likely option. He’s publicly stated that “a REIT is highly logical”, and that they’re “seriously focused on a REIT going forward”. Underscoring this is HBC’s recent hiring of a CFO with experience creating of a company-related REIT.
“We're focused on analyzing every different alternative there can be, but I think a REIT is highly logical.”- HBC’s CEO on the Saks Acquisition Call, 7/29/13
“We are seriously focused on a REIT going forward,” HBC chief executive Richard Baker said in an interview. “We think this (the Queen’s Street sale-leaseback) was a good first step towards getting a REIT done.” http://tinyurl.com/SerioslyFocusedonREIT- HBC’s CEO in a Globe and Mail Interview, 1/27/14
Valuing the Real Estate
We get to an estimated real estate value of $5.2 b using a 4.75% cap rate on an estimated annual rent expense of $246 mm. To value the real estate, we estimate the level of rent that their various property types could support and apply various cap rates for the different property types and locations.
Estimating the Potential Rent
To get to an estimated rent expense, we first calculate the total amount of HBC’s fee-owned and ground-leased real estate, which totals 13.58 mm square feet. We’ve modeled this out by the different banners and property types (flagships vs non-flagships), but for the sake of simplicity we will address this on a consolidated basis here.
Taking the 13.58 mm of owned square footage, we apply sales per square foot figures given by the company for the different banners, which ultimately translate to an overall sales per square foot level in-line with peers at $247. Taking the product of the two, we get to $3.352 b in estimated sales from owned real estate. Applying an 11% EBITDA margin, which is the midpoint of the 10-12% range for peers and HBC’s long-term target, we estimate EBITDA from owned real estate of $370 mm (keep in mind that the EBITDA margin from owned real estate should be higher than the overall company EBITDA margin due to the lack of rent expense).
Assuming a 1.5x ratio of EBITDA to rent (rent coverage ratio), we get an estimated rent of $246 mm. This is a rent-to-sales ratio of 7.4%, or roughly $18 per square foot. For perspective, we look to a recent study by Integra Realty Resources (a national real estate valuation and consulting firm) that places the average rent to retail sales ratio at 9.8% (
http://tinyurl.com/Rent-To-Sales), making the 7.4% calculated here seem conservative. Validating this is the recent sale-leaseback of the Toronto Hudson’s Bay flagship store and adjacent office tower that achieved $24 in rent per square foot ($30 mm in rent for a combined 1.244 mm in GLA).
Applying a Cap Rate
The next step to valuing the real estate is to apply different cap rates to the portfolio of properties:
Hudson’s Bay:
For the top 3 Hudson’s Bay downtown flagship stores (Vancouver, Montreal and Calgary), we assume a 4.5% cap rate on $20.3 mm in estimated rent, returning a value of $451 mm. This is 50 bps wide of the 4.00% cap rate achieved in the $650 mm sale-leaseback of their Toronto Hudson’s Bay flagship store. While the overall cap rate was 4.75% in that transaction, according to the company, this 4.75% cap rate broke down to a 4.0% cap rate on the Toronto flagship store and a 7.0% cap rate on the office tower. For the remaining Hudson’s Bay stores, we assume a 5.25% cap rate on $17 mm in estimated rent, returning a value of $323 mm. This cap rate is in-line with the 5.25% weighted average cap rate for regional malls.
Lord & Taylor:
For the Lord & Taylor flagship store on NYC’s 5th Avenue, we assume a 4.5% cap rate on $13.1 mm in estimated rent, returning a value of $292 mm. For the remaining Lord & Taylor stores, we assume the 5.25% regional mall cap rate on $76.3 mm in estimated rent expense, returning a value of $1.454 b.
Saks:
For the Saks 5th Avenue flagship store in NYC, we assume a 4.0% cap rate on $65.3 mm in estimated rent, returning a value of $1.633 b. For the remaining Saks stores, we assume the 5.25% regional mall cap rate on $54.3 mm in estimated rent, returning a value of $1.034 b.
Consolidated:
On a consolidated basis, these assumptions imply a real estate value of $5.2 b and an overall cap rate of 4.75%. This 4.75% cap rate breaks down to 4.1% for Manhattan retail, 4.5% for the other downtown flagships, and 5.25% for their non-flagship assets. Furthermore, according to comments from VNO’s recent earnings call, cap rates on Manhattan retail real estate are 3.6%, suggesting that the 4.1% cap rate applied for these assets could be conservative.
“There has been a lot of hubbub lately about Manhattan Street Retail. This asset class is now drawing a lot of attention, and some of our industry brethren are now jumping on the bandwagon that we have been on for the last 15 years. This asset class has been and continues to be the best performing of all retail asset classes, benefiting from increases in tenant sales, rapidly rising rents, rabid investor interest, and most importantly, extremely limited supply meet extreme scarcity. Our largest and best-in-class Manhattan Street Retail portfolio consists of 2.8 million square feet and 63 properties with EBITDA of over $310 million per year, and growing.
To demonstrate the uniqueness of this asset class, Green Street uses a 3.6% cap rate to value our Manhattan Street Retail assets, which is 100 basis points lower than the rate they use to value the best mall portfolio, and 80 basis points lower than the rate they use to value the best office portfolio in Midtown, Manhattan.
In the private market, Manhattan Street Retail assets, depending on exact location and specifics of lease encumbrances, can even trade at sub-3% cap rates.” - VNO’s Chairman and CEO Steven Roth from the 2Q14 earnings call
Regional Mall REIT Comps
See report download link
Valuing the HBC REIT
To value the HBC REIT, we begin by assuming a debt/EV level in-line with regional mall peers at 40%. This implies that $2.075 b of HBC’s $2.815 b in net debt will be transferred to the REIT, leaving the retail business with $740 mm in net debt prior to any sales of their stake in the HBC REIT and FCF generation.
Subtracting the $2.075 b of REIT net debt from the real estate value calculated earlier returns $3.1 b of REIT NAV, or $16.43 per diluted HBC share (189.5 mm diluted shares at our target). Assuming the REIT trades at 1x NAV (mall peers trade at a 2% premium to NAV) and a 10% holdco discount, we get to a valuation for the REIT shares of $14.79. Excluding the 15% stake HBC is likely to IPO, the value of the REIT retained by HBC under the base case is $12.57.
To probability weight this base case scenario, we assume a bear and bull case scenario that applies a cap rate 25 bps higher and lower than the 4.75% used in the base case. We then probability weight the bear, base, and bull scenarios at 35%, 50%, and 15%. This returns a probability weighted valuation for HBC’s stake in the REIT post an IPO sale of $12.45.
Assuming $15 mm in annual SG&A, a borrowing cost of 4.9% (the average effective interest rate of GGP at 4.6% and SPG at 5.2%), $10m in annual capex, and a 90% payout ratio, we calculate AFFO of $120 mm, AFFO per share of $0.63, and dividend of $0.57.
This translates to a P/AFFO of 23.4x and a 3.8% dividend yield. For reference, the average P/AFFO for regional malls is 21.3x, and the average dividend yield is 3.2%. The discrepancy regarding the dividend yield is mainly a function of us assuming a 90% payout ratio vs peers at 67%, and assuming a 67% payout ratio, the dividend yield for HBC’s REIT would be 2.9%.
Valuing the HBC Retail Business
These assumptions return EBITDA estimates for 2015 and 2016 of $679 mm and $779 mm, respectively. From this, we subtract out the $246 mm in annual rent expense calculated previously, leaving post-rent EBITDA of $432 mm and $533 mm respectively.
We then apply a 6.84x EV/EBITDA multiple, which is the peer group’s 1-year average multiple based on the current fiscal year (DDS at 6.0x, JWN at 7.96x, and M at 6.56x). We think a multiple in-line with peers is permissible, as HBC will have leverage levels similar to peers after transferring debt to the REIT. Specifically, we calculate HBC’s retail opco as having a net debt/EBITDA ratio of 0.9x in 2015 (vs peers at 0.9x), and 0.6x on 2016 (vs peers at 0.9x). Applying the 6.84x EBITDA multiple returns an EV for the retail operations of $2.96 b and $3.64 b for 2015 and 2016.
To get to an estimated net debt for the retail operations, we start with HBC’s current $2.815 b in net debt, then subtract the $2.075 b in net debt transferred to the REIT, leaving $740m in retail net debt. From there, we take out the net proceeds from the 15% stake sale of HBC’s REIT, which equate to $344 mm ($467 mm in gross proceeds less an 8% IPO fee and a 20% tax rate). We then subtract the free cash flow to equity generated in 2015 and 2016, which we model at $12 mm and $80 mm respectively, including the after tax value of the REIT dividends received. Accounting for these adjustments produces net debt estimates for 2015 and 2016 of $384 mm and $304 mm, respectively. This leaves us with $2.57 b and $3.34 b in retail equity value, or $13.58 and $17.63 per share, respectively.
Summary Valuation and Upside
Combining the $12.45 in probability weighted value of HBC’s post-IPO REIT stake, the $13.54 retail value on 2015 estimates, and the $17.53 in retail value on 2016 estimates, we get to a 2015 price target of $26 for 49% upside, and a 2016 price target of $30 for 72% upside. This 2016 target implies an IRR of 35%.
Potential for Further Upside from Productivity Improvements
In addition to the value identified above, further upside can be realized from strategies management is undertaking to maximize store productivity. HBC believes that their real estate worth more than the EV of the entire company. Implicit in this belief is that the productivity of the owned real estate, particularly the NYC 5th avenue flagship store, can be increased.
An exhibit from the September 2013 presentation illustrates this opportunity nicely. It shows how Hudson’s Bay and Lord & Taylor productivity, at $140 and $218 in sales per sq ft, is 44% and 13% below the department store average of $250. Management’s 3-5 year target is to close that gap, increasing Hudson’s Bay productivity by 25% to $170-180, and increasing Lord & Taylor productivity by 12% to $240-250. It also shows the opportunity for improvement in the luxury space, with the overall productivity of Saks at $437 or 31% below that of the $629 achieved by Neiman Marcus.
The most significant opportunity to create value by increasing productivity is at the Saks NYC flagship building located on NYC’s 5th Avenue. According to HBC representatives, Harrod’s in London is twice as productive as the Saks NYC flagship, and the Galeries Lafayette in Paris is 3x more productive. Management has specific plans for significantly increasing the sales and EBITDA of the property, believing that they can optimize that space with some simple changes.
They plan on investing $250mm there over the next 3 years, which is expected to result in an extra $250mm in sales, or a 36% increase. This would increase sales per sq ft from $437 to $594, significantly closing the gap to the $629 achieved by Neiman Marcus. As a cross check, this is in-line with the productivity increase they achieved from the major renovation they recently undertook at their Hudson’s Bay Vancouver flagship store, with management stating on the September 2013 earnings call that this renovation resulted in a sales increase of 35%.
These plans include converting the building’s basement salon into an additional floor of retail space (adds 4-5% to retail space), installing atriums that open the basement to the first floor, and installing escalators connecting the first floor to the basement. They also plan on driving more traffic to the second floor by making their four corner super-luxury areas (Louis Vuitton, Gucci, Prada etc) two stories instead of one. This is intended to bring the excitement of the first floor onto the second floor. They also plan to expand their shoe floor space by moving the restaurant, which is currently part of that floor.
Even more interesting is the fact that the company says that these capital improvements won’t affect any REIT plans, as they would factor these improvements into the sale price and rent when the assets are transferred to the REIT.
Risks
Uncertainty Around Monetization Strategy and Timing- There is uncertainty around what the monetization strategy will be, and the execution of any strategy to monetize the real estate could take longer than expected.
High Current Leverage- HBC currently has a leverage level much higher than peers, at 4.7x 2014 EBITDA vs peers at 1.0x. However, as they are seeking to monetize their real estate, we believe that this level of leverage is manageable and will decline to a level more in-line the group following a REIT transaction.
Aggressive 2018 Targets- Management has put out some fairly aggressive targets for 2018, targeting approximately $10 b in sales with a normalized EBITDA margin in the 10-12% range.
Single Tenant REIT Risk- If HBC chooses to create a REIT, it will be a single tenant REIT initially, making it completely reliant on the cash flows from HBC’s retail operation. Offsetting this in the valuation is the high quality of HBC’s portfolio. However, there is a risk that investors overly discount the HBC retail REIT initially until it has an opportunity to more fully diversify its tenant base.
Foreign Currency Risk- Fluctuations in the USD/CAD exchange rate can impact HBC’s results. HBC’s stock price and earnings are denominated in Canadian dollars, but the majority of their revenue is in US dollars.
Interest Rate Risk- Rising interest rates are typically bad for REIT valuations, as cap rates expand. A sharply rising interest rate environment could pressure the valuation of an HBC REIT or make it a less attractive investment relative to alternatives.
Retail Risk- Given HBC’s business is the retail business, they are subject to risks applicable to all retailers including the ability to grow same-store sales, potential impacts from extreme weather conditions, weakness in discretionary spending, a potential shift in consumer preferences,
Risks from the Saks Integration- Management is currently integrating the large Saks acquisition, which could take away from their ability to manage the core business. Also, they may not be able to deliver on their estimated $100 mm in annual cost synergies by the third year after the acquisition.
Concentrated Ownership Structure- HBC has a concentrated ownership structure with a four entities holding 59.4% of the fully diluted shares.
Potential Private Equity Share Distributions- HBC’s stock price was pressured over the summer, underperforming the S&P Retail ETF (XRT) by -8% and the S&P 500 by -6%. This was likely the result of 58 mm shares of supply that came to the market through a secondary offering and a subsequent share distribution by HBC Luxembourg in early June. Company filings indicate that they intend to distribute an additional 9.6 mm shares or 5.3% of the common shares.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.