No one has ever accused me of being a fashionista – at least not fairly. But over the past few months, I've been shopping at various Hudson's Bay department stores, hoping to elevate my wardrobe standards. Although colour co-ordination issues remain, I have been getting – and appreciating – the staff's personalized help.
These visits, l confess, have an ulterior motive. I am examining the stock (HBC-T) as an equity investment for clients. As Fidelity's most famous money manager, Peter Lynch instructed, the first step in due diligence, out of many, is to try the product.
So with this in mind, and after my successful experiences, I decided it was time to look at the company as an equity investment for my clients.
And, here's what I've learned: Hudson's Bay is actually a real-estate company masquerading as a retailer.
Let me explain.
In North America, Hudson's Bay Company (Canada) owns 100 per cent and includes in its quarterly results each of the flagship stores and chains of Saks Fifth Avenue, Lord & Taylor, Gilt, Home Outfitters, as well as the German operating company, the Galeria Kaufhof Group with its stores and real estate in Europe. HBC also owns – but does not include in its quarterly results – other properties inside two joint ventures, one with Simon Properties (HBS Global Properties), and the second with RioCan (RioCan-HBC joint venture), to which the retail operations effectively pay rent.
So is it a retailer or real-estate landlord? HBC owns and controls nearly 50 million square feet of gross leasable space in Canada, the U.S. and Europe. This includes joint ventures; ground leases or sites subject to sale/ leaseback arrangements (such as the downtown Toronto store and office tower); and premier real estate such as Saks' Fifth Avenue store in Manhattan. In other words, HBC is among the biggest lessors of real property in Canada and in North America.
So what is it all worth? About a year ago, HBC sold an equity stake in HBS Properties to three different parties for a total of $533-million (U.S.); HBC said in its annual report that this implied a value for the whole joint venture of about $4.5-billion. And the joint venture controls only a portion of the assets that Hudson's Bay Company owns. Certain prize assets such as Saks Fifth Avenue store in New York and the Lord & Taylor Store were excluded from that transaction.
To determine what the whole pie is worth as two separate companies – the retail operations and the real estate – requires looking at the operating income split and then valuing each part. The math works like this: The estimated EBITDAR (earnings before interest, taxes, depreciation, amortization and rent) for 2016 for both is a little more than $1.5-billion (Canadian). Assume that Hudson's Bay put all its real estate into a new legal entity – a real estate investment trust (REIT), for example – and had the new entity lease space to the retail divisions.
According to recent company investment presentation, the retail division could pay the new unformed REIT about $650-million as rent. That leaves about $850-million, of which about $525-million would be paid to third-party landlords; the remaining EBITDAR comes from retail operations.
So that's how operating income would be split. But what would the REIT be worth as a stand-alone entity? That's relatively straightforward. Using a blended capitalization rate on the net operating income generated from real-estate assets, I calculate a gross value before debt of a little over $13-billion.
Secured against these prized assets is about $6-billion of debt, implying equity attributable to HBC's ownership (not everything is 100 per cent owned) of over $6-billion. With 182 million shares outstanding, the real estate is worth greater than $30 per share on a stand-alone basis, even before factoring in the retail operations – which are profitable and not insignificant. HBC's stock is currently trading in the $17 range and its market capitalization is about $3.1-billion.
So where's the catch? The real-estate value needs to be extracted from the mother ship. Difficult? Not really. The template for such extraction is already well understood – the most recent high-profile examples being Canadian Tire and Loblaw Companies, both of which within the past several years have spun out their store real estate assets into REITs.
And, as luck would have it, HBC'S chief financial officer, Paul Beesley, executed exactly this kind of transaction a decade ago. As CFO of the Sobey-family-controlled Empire Co., he financially engineered the successful extraction of their grocery store real-estate assets into Crombie REIT.
Given the real-estate value HBC management – Richard Baker, Gerald Storch and Mr. Beesley – have been creating for years, I'm convinced that The Three Amigos will finish the job they started, and form a real-estate REIT with HBC's assets that will reward all shareholders generously.
Gabriel Lowenberg is CEO and President of Lowenberg Investment Counsel, Inc. (LICi), an independent wealth management firm which owns Hudson's Bay Company shares for the benefit of its clients.