After Hudson's Bay Co. announced on Tuesday morning that it is selling its flagship Lord & Taylor store in New York, investors who had bet on the retailer for its vast real-estate holdings were vindicated: Turns out, store space is worth more than many observers had expected.
So why is HBC's share price still in the doldrums?
The sale was initially greeted with enthusiasm. HBC shares surged as much as 7 per cent when trading began on Tuesday.
Investors liked the price that the Lord & Taylor store on Fifth Avenue had gone for: $850-million (U.S.).
The details also look good. The retailer, which also operates the Bay, Home Outfitters and Saks Fifth Avenue, will continue to occupy 25 per cent of the current space.
The rest will serve as the global headquarters for the company that is involved in the purchase – WeWork Cos., which provides office space to entrepreneurs and startups in 55 cities globally.
Rhone Capital, which has formed a joint venture with WeWork for the real estate transaction, has also agreed to a $500-million investment in HBC, in the form of preferred shares that can be converted to common shares within eight years.
However, the rally that immediately followed this news has since sputtered. HBC shares on Wednesday were back below $12 (Canadian), down 5.5 per cent since Tuesday morning and down 10 per cent over the past month, even as analysts raised their price targets on the stock.
Mark Petrie, an analyst at CIBC World Markets, raised his target to $14 from $12.50 previously. Brian Morrison, an analyst at TD Securities, raised his target to $13.50, also from $12.50.
The hikes reflect the idea that one of the key arguments in the bearish case for the stock – that former retail real estate might not be worth much – appears to be weak. After all, the Lord & Taylor flagship store went for 30 per cent more than its most recent appraised value in July, 2016.
That was more than analysts had been expecting. In raising his target price on the stock, Mr. Morrison commented: "The key driver of the increase pertains to the sale of the L&T flagship above what we had been previously accounting for."
Of course, HBC has a sprawling empire of real estate, and perhaps not all of its stores will be as desirable as Fifth Avenue. Nonetheless, some observers have argued that the value of this real estate towers above HBC's actual market value, creating an upside opportunity for anyone willing to bet on further store sales or an outright spinoff of the real estate into a separate company.
Earlier this year, an analyst at BMO Nesbitt Burns Inc. pegged HBC's per-share value as high as $36, or about three times the current price.
Clearly, the market is not onside with this bullish assessment, and for a couple of reasons.
For one, the deal announced on Tuesday has at least one quirky element that is sure to rankle bullish enthusiasts: The preferred-share agreement with Rhone Capital stipulates that the holdings can be converted into common shares priced at $12.42 a share.
This conversion will dilute current shareholders. But more importantly, the conversion price, just 5.7 per cent above the current price, appears to undermine the intrinsic value of the company if its real estate is worth as much as some observers believe.
As Mr. Morrison explained in a note: "For a company stating that the value of its real estate is worth in excess of $35 a share, it seems at odds to be selling about 22 per cent of its pro forma equity at $12.42."
There is also the issue of rent. One of the big problems with HBC spinning off or selling its real estate is that retailer will have to pay its landlord. And that's a problem given the current competitive headwinds facing bricks-and-mortar retailers in general, and HBC specifically.
"The equity investment brings much needed cash, but the vast majority of cash flow is still needed for rent," Mr. Petrie said in his note, which estimated that 66 per cent of estimated 2018 cash flow will be required to keep the lights on.
He added: "While there is potentially attractive upside in future real estate moves, the complicated structure, lack of transparency and operational uncertainty hold us back and we maintain a Neutral rating."
He's not alone, which is why the stock requires a lot of patience.