Description

Idea:

Hudson Ltd. (“Hudson”, the “Company”) is a North American based, predominately airport-exposed, travel concession operator that was carved out of the global duty-free giant Dufry (DUFN.SW) in 2018. The Company, which is likely most familiar to Northeast readers for its “Hudson News” locations, operates roughly 1,013 stores across 88 transportation hubs spread across the U.S. and Canada. I believe that Hudson’s common stock, on account of the Company’s variable cost structure, attractive product-mix, beneficial relationship with its parent Dufry, and favorable exposures to both the U.S. domestic travel market and a predominately government-owned landlord base, provides an attractive way to profit from the eventual normalization of domestic travel.

Industry Overview:

Historically, the airport travel retail industry has been characterized by attractive structural tailwinds and powerful landlords. The industry serves a captive, growing customer base (global air travel has grown at an annualized 4.4% CAGR since 1970). Furthermore, thanks to increases in spend-per-passenger due to rising dwell time in airports and marketing efficiencies, Barclays estimates that, pre-COVID, travel retail had grown at 1.8x underlying passenger volumes since 2002—exhibiting nearly a 9% CAGR (a threefold increase over the period). However, the attractiveness of the end-market demand coupled with a finite supply of venue inventory consolidated a lot of power in the hands of the suppliers (i.e. airport operators); the competitive bidding process for new contract tenders led to the emergence of a concession regime with increasing minimum annual guarantee’s (MAG’s) that effectively transferred (until now) much of the passenger volume risk from the airports operators to the concessionaires. Presently, the state of affairs is quite different: COVID-19 has upended the global travel industry—passenger numbers are beginning to inch upwards after plummeting in late March as the international community slowly rebuilds bilateral “travel corridors”. The International Air Transport Association (IATA), after multiple downward revisions, presently forecasts that global passenger numbers for 2020 will be 49% of 2019 levels, with 2021 passenger numbers as low as 74% of 2019 numbers. As of the date of this publication, the year-over-year change in TSA checkpoint travel numbers —the de facto barometer for the industry which is published daily—is roughly down 75% after recovering from the shocking lows of -96% down in late April.

Key Insights / Themes:

Variable Cost Structure / Cash Runway: Travel retail operators historically have three large buckets of fixed costs: charges related to fixed employees (cashier, store manager, etc), minimum annual guarantees contained within their concession agreement (more on this later), and fixed overhead (utilities, essential maintenance & repair, etc). During lockdown, the Company moved quickly to close more than 700 of its stores, furloughed the majority of its employees, and secured rent abatements / deferrals from landlords in the form of MAG waivers (30-50 MM expected in Q2 vs ~50 MM of fixed rent expense in 2Q’19). Hudson ended May with a $204 MM cash balance vs $225.6 MM on March 31st—equating to an impressive average monthly burn of just ~11 MM over a brutal two month period during which passenger levels were at their nadir. Following the Company’s cost reduction efforts (primarily reducing headcount--esp. temporary/seasonal employees—and pushing landlords to pivot in the near-term to a variable rent regime) the Company expects to reach store-level breakeven at ~50% of 2019 revenue and estimates decremental EBITDA margins will be between 30-50%. Although there remains uncertainty regarding reopening economics (the need to pay suppliers + build inventory consuming working capital, risk of reopening prematurely exacerbating cash-burn, difficulty of reclosing operations in the event of a second wave) I believe both the Company’s ability to selectively reopen stores and the level of support shown by landlords regarding MAG waivers provides some cause for optimism. With $204 MM of cash on the balance sheet, JV partners sharing in 20% of cash burn, and recent success negotiating with landlords, I believe HUD should have ample liquidity to weather the storm.

Favorable Travel Market: Roughly 80% of Hudson’s revenue comes from the U.S. (the remainder emanating from Canada), which is one of the largest domestic travel markets in the world (an estimated 85% of U.S. originated flights have domestic destinations). Given the current precedent of piecemeal bilateral international travel agreements, it is widely expected that domestic travel will recover much faster than international travel (a fact already borne out in countries such as China where domestic volumes have recovered while international volumes remain near the lows). Although recent measures taken by states such as CT and NY to enforce a 14 day quarantine on visitors from choice “high-risk” states potentially challenges the notion of a united domestic American travel market—I believe that over the next 5 months inter-state travel will inevitably prove to be one of the first travel markets to recover (it is also notable that the TSA data did not exhibit a marked decline in the days following the pronouncement).  

Favorable Landlord Base & MAG’s: As mentioned previously, most outstanding concession agreements contain language stipulating a minimum annual guarantee payable to the airport by the tenant. While across the industry there a variety of contract structures, the typical concession contract guaranteed the airport the greater of a minimum annual dollar amount of rent or a stipulated % of turnover. The unprecedented nature of COVID-19 (which forced most airports to close down infrastructure to conserve cash) proved to be an environment in which enforcing MAG’s was virtually untenable. Therefore, the lion-share of MAG’s across the US/Europe, have been, for the moment, made variable. While it remains to be seen as to how the dynamic plays out in the long run, the crisis may foment a greater sharing of the risk/reward between landlords and tenants in the form of fully turnover based rents or the establishment of JV partnerships. While I am not fully convinced this will play out, I do believe precedent negotiations (see Dallas Forth Worth Agreement with 3Sity Duty Free) in the U.S. suggest that MAG levels, at the very least, will be modulated in the near/medium term to be broadly in-line with passenger numbers. I believe that US airports, which are predominately owned by local governments and more focused on maximizing public utility rather than private gain, will be more amenable to establishing supportive relationships with their tenants than their European counterparts. CAPA (The Centre for Aviation) estimated that in 2019 over 50% of European airports had some degree of private ownership; this contrasts with the United States where the overwhelming majority are owned by local-governments. I believe this relationship is exemplified by Hudson’s parent, Dufry, whose tenant base has a much greater exposure to privately owned operators—Dufry’s total concession expenses (fixed + variable, pre-IFRS 16) as a % of revenue has been historically 500-700 bps higher than Hudson’s.

Product Mix:  Historically, Hudson’s sales have been split 22%/78% between duty-free/duty-paid; within duty-paid Hudson operates both specialty retail stores and convenience stores. Although Hudson has declined to disclose the break-out between the two—you can get a sense from the respective product mix from the pie chart below (provided in their Q4 2019 Earnings Presentation). I find the 40% F&B and 8% literature exposures to be particularly attractive for the following reasons:

• Impulse Purchase Decision: These categories are typically the product of an “impulse purchase decision” which have been historically resilient to ecommerce.
• No Frills = More F&B Opportunity: The mix of traffic recovery (leisure rebounding faster than business) and consumer preferences (price sensitive, avoiding metro-hubs) have begun to favor point-to-point traffic serving to advantage low-cost carriers over network carriers (this thesis is already playing out in global carrier data with LCC’s taking share in the Chinese domestic market). These low-cost carriers typically espouse a “no frills” operating approach that is light on in-flite F&B options providing further opportunity for Hudson’s services.
• Low ATV’s: If passenger volumes are 30% lower (through a combination of diminished terminal passenger traffic and/or reduced store servicing capacity due to social distancing requirements) it is more tenable for Hudson to raise prices by 50% on a $2.50 bottle of water vs a $120 pair of luxury shoes to reach the same level of sales. This dynamic should also help offset some of the negative mix-shift in passenger spend that could be brought to bear by a decrease in Chinese passengers (typical spend is 11x the average of travelers from other countries), increase in low-cost carrier traffic (typical spend is 7% less than average traveler), and potential declines in purchasing power that would be felt more acutely in Hudson’s other product categories such as fashion or watches & jewelry.

Relationship with Dufry: Hudson’s relationship with Dufry confers some significant advantages; Hudson’s only material financial indebtedness is $498.4 MM (per March 31, 2020) of maintenance covenant-light intercompany debt; Hudson has the ability to borrow additional debt from Dufry (although yet to be exercised) and has been able to avoid expensive dilutive equity issuances undertaken by many industry participants (such as SSP, Dufry, and The Restaurant Group) preserving upside potential; Hudson benefits from Dufry’s operational and executive oversight (Hudson shareholders get the benefit of best-in-class managerial stewardship at a small-cap company). Additionally, Hudson is currently not a guarantor to Dufry’s financial debt and is unlikely to become one in the future (a certain threshold for non-guarantor subsidiary debt would have to be breached). Although one may worry that the parent Dufry could theoretically be forced to blow out of its remaining stake in Hudson if were to become in desperate need of liquidity, I would point out the strategic role (domestic travel market exposure) Hudson plays and the special attention Dufry management has indicated towards the division during recent earnings calls. While if Dufry was to run into financial trouble it would be problematic for Hudson, I believe that there are measures the Company could take to protect itself (pulling cash out of the presently shared treasury function, borrowing from third parties to pay down intercompany debt, etc.).

Valuation:

I value Hudson based on my estimate of normalized earnings, which is sensitized for various topline outcomes. The -25% revenue scenario is in-line with IATA’s global 2021 passenger estimate.

Risks:

•  Second-wave reverses recovery in domestic travel

• Premature-reopening exacerbates cash burn

• Contagion risks in the event of financial distress at parent Dufry

Catalyst

Normalization in air traffic demand