A pedestrian walk past the Hudson's Bay Company store on Toronto’s Queen Street on July 3, 2014.Fred Lum/The Globe and Mail
You can often tell when corporate leaders are excited by measuring their volume of buzzwords – the more they use, the merrier they typically are.
Following this rule of thumb, Hudson's Bay Co. governor Richard Baker was practically ecstatic when announcing his new real estate projects earlier this week. In his words, the deals are a "transformative step" that will undoubtedly "drive value creation."
The two joint ventures are complicated transactions, but they look good on paper because they quickly boost the value of HBC's real estate, so shareholders sent the company's stock soaring 23 per cent when the market opened Wednesday.
Two days have since passed, and some calm number crunching suggests the same investors should reconsider a few of their early assumptions.
HBC's debt repayment is one of the hot topics. By selling properties to the two new ventures – one in Canada, the other in the United States – HBC gets cash upfront that will be used to eliminate $1.1-billion worth of debt on its balance sheet. That's big news for the retailer, because analysts and rating agencies have worried about the company's leverage ever since it bought Saks Inc. for $2.9-billion in 2013, largely with borrowed money.
HBC's debt load is expected to fall to $1.4-billion from $2.5-billion, and the company's ratio of debt to earnings before interest, taxes, depreciation, amortization and rent drops to 3.75 times from 5.3 times, all of which sounds fantastic.
But there's more to it. Although HBC will reduce debt on its corporate balance sheet, the funds to do so will come from borrowed money. To raise cash, the company is taking out new mortgages on properties sold to the joint ventures.
HBC argues such borrowing is prudent because the new debt won't sit on its corporate balance sheet. Instead, the company will use what is known as the 'equity method' of accounting for the joint ventures, which means each venture will appear only as a single line item on the balance sheet. This disclosure will likely show nothing more than the equity value – total property value less debt.
But let's be clear: the mortgage debt in that equity calculation is still tied to HBC because the company will hold 80-per-cent stakes in both joint ventures. In some ways, then, HBC is simply paying off its Visa by using its MasterCard.
For the legal wonks out there, HBC can do this because the joint venture partners have been given a say in major decisions, even though they will be minority owners. Canadian Tire, by contrast, can't use the same accounting method because it has full control over its REIT.
HBC's rent payments raise another red flag. The retailer will lease its properties back from the joint ventures, and CIBC World Markets analyst Perry Caicco worries the rent payments are too pricey.
HBC will pay $26 per square foot to the Canadian joint venture – a gross rent to occupancy cost of 14 per cent. Mr. Caicco argues that level is "far beyond what most landlords would consider safe and reasonable," in a note to clients. "In reality, a 'safer' rent would have been about $14 per square foot – more in line with, but still above, 'anchor' tenant rents." (For its part, HBC has said this is a fair market rent that was agreed upon by all parties in the ventures.)
The analyst wonders if the $12 difference per square foot will help the joint venture pay interest on its mortgages. If you consider that these mortgages provided HBC with its cash for the corporate debt repayment up front, there's an argument to be made HBC could be paying itself in a roundabout way.
Finally, HBC shareholders were quick to believe that the retailer's real estate is now worth much more than they originally assumed. The change of heart came after the two joint venture partners, RioCan REIT and Simon Property Group, each bought 20-per-cent stakes in the new companies, giving the properties public valuations.
Like many others, Mr. Caicco updated his models to reflect the change. Still, he remains a bit hesitant. "Essentially, HBC has found partners who are willing to contribute small sums of money and/or minor properties for a fractional stake in a joint venture, and then imply that the entire venture is worth what the two parties have decided to value it at. That requires a leap of faith we are not entirely willing to make," he wrote.
Tim Kiladze