"Yo ho ho! There's scurvy up ahead!"

“Yo ho ho! There’s scurvy up ahead!”

Hudson’s Bay Company (HBC:TSX) is Canada’s oldest company, incorporating in 1670 so the English could harvest Canada’s ample bounty of furs rape the wilderness of everything that wasn’t nailed down. King Charles II gave the company exclusive control of what was called Rupert’s Land, which was named after his brother, Prince Rupert. Rupert’s land stretched from Northern Ontario all the way west into now what is British Columbia, some 15% of North America’s land mass. Because of its advantaged position in the fur trade, HBC ended up dominating trade in Canada, especially after merging with long-time rival Northwest Company. Then, in 1869, HBC transferred Rupert’s Land to the newly formed Dominion of Canada, which paved the way for the country’s current form. That was nice of them, huh?

Hudson’s Bay adjusted from its days of fur trading and post building in a few ways. It pioneered the idea of the department store in Canada, building large stores in the downtowns of new cities like Calgary, Winnipeg, Vancouver, Edmonton, Saskatoon, and Victoria in the early 20th century.

From there, the company expanded into all sorts of alternate industries. It got back into the fur business. It acquired real estate. It even got into the oil business, starting in 1926. It grew to the point where the company’s oil subsidiary was the 6th largest producer in Canada by the late 1960s. HBC got out of the oil business in the early 1980s.

HBC also kept expanding its retail operations. In 1960 the company acquired Morgan’s, a retail chain in Eastern Canada, which came with prime real estate in both downtown Toronto and Montreal. In 1978 after successfully dodging a hostile takeover from upstart discount chain Zellers, Hudson’s Bay then acquired the discounter. It held Zellers until 2011, when Target announced it would acquire Zellers’s best locations, shuttering the rest.

The retail business

HBC is still busy these days. The company currently runs stores under the following banners.

  • Hudson’s Bay (90 stores)
  • Lord & Taylor (49 stores)
  • Saks 5th Avenue (39 stores)
  • Outlets (Saks Off 5th) (78 stores)
  • Home Outfitters (69 stores)

HBC acquired Saks 5th Avenue during the fourth quarter of 2013, meaning it only has three quarters worth of sales with the two combined entities. Based on the first three quarters of this year, management expects total sales of between $7.8 and $8.1 billion (all dollar figures are CDN $, unless noted), with an “normalized” profit of $580 to $620 million. Normalized profits are simply EBITDA.

Regardless of whether investors use management’s numbers or traditional accounting metrics, the future looks strong. Recent results saw same store sales growth rise 19.2% at Off Fifth, 1% at Saks, and 1.7% across Hudson’s Bay and Lord & Taylor. Growth is especially being driven by the company’s websites, which collectively grew 73% YOY at the combined Hudson’s Bay and Lord & Taylor banners. Saks also had strong web results.

There is significant potential going forward for HBC to bring the Saks brand to Canada. It already has plans to open a Saks location in its flagship location in downtown Toronto during the first half of 2016. Other locations are planned in many of the company’s downtown locations across the country, with plans to open up to 7 Saks locations, 25 Off 5th outlet stores, and launch corresponding websites for both brands. Management plans for this to happen by 2018.

Aggressively growing Off 5th has another advantage, allowing slow moving luxury merchandise in higher end stores to be shipped to outlet centers rather than simply reduced to clear at the store in question. This should allow the company to get a higher price for its slower moving items.

Put all this together, and the company expects to growth both revenue to $10 billion by 2018 and grow EBITDA by 10-12% annually along the way. Keep in mind that, based on the company’s current market cap of $4.33 billion and its net debt of $2.85 billion (which includes operating leases), the company currently trades at an EV/EBITDA ratio of approximately 12x.

For a retailer, looking to grow 10-12% a year, those aren’t bad numbers. But what if I told you that the company’s retail business was simply gravy, and that at current valuations, you’re getting it for free?

The opportunity

Remember all that real estate HBC acquired over the years? It turns out it’s worth a lot of money.

In late 2013, HBC entered into an agreement with Canadian retail real estate giant Cadillac Fairview to sell its crown jewel property, located on Queen Street in downtown Toronto. This real estate is among the most valuable in the country. It raised $650 million from the deal.

That’s not all. Recently, management looked to raise capital to fund renovations to the Saks building on 5th Avenue in New York City, which might be the most valuable piece of retail real estate on the planet. As part of the deal, the lender got the building appraised.

It came in at $3.7 billion (U.S.). Needless to say, HBC easily got the $1.25 (U.S.) billion loan it was looking for.

I don’t want to understate how important this is. Converted back to Canadian Dollars, the Saks building in New York City is worth $4.1 billion. HBC only paid $2.9 billion (including assumed debt) for the whole company back in 2013.

Saks doesn’t just come with a fancy New York building either. It also owns real estate across the U.S., including 156,000 square feet on Wilshire Boulevard in Beverly Hills. This is also extremely valuable real estate.

There’s more. As part of the company’s acquisition of Lord & Taylor in 2006, HBC owns its flagship location in New York City, which is on 5th Avenue, just a few blocks south of the Saks building.

Additionally, in Canada, the company has held on to some of it’s valuable real estate acquired over the years. Highlights are:

  • 674 Granville Street, Vancouver. 637,000 square feet over 9 floors, located close to the financial district and a shadow anchor to Pacific Place, one of Canada’s best grossing shopping malls.
  • 585 Ste-Catherine Street, Montreal. 655,000 square feet over 9 floors, located on Montreal’s busiest retail street.
  • 200 8th Avenue SW, Calgary. 449,000 square feet over 7 floors, located just one block away from Calgary’s LRT line.
  • 73 Rideau Street, Ottawa. 335,000 square feet over 6 floors, located in the Byward Market area, the main retail and entertainment district.
  • It also owns other locations in Canada, most notably its building in downtown Winnipeg, which is 656,000 square feet. That building has been declared a heritage site, making it difficult to sell. Less than half its area is currently in use.

Locations in Victoria, Edmonton, Saskatoon, and Regina have been sold in the past.

Put it all together, and what’s this real estate worth? Well, it depends on who you ask.

A report by Canadian analysts M Partners puts the value of the real estate at $15 per share, or approximately $2.7 billion. These reports came out before the Saks building was appraised at $4.1 billion. I think they’re a little low.

CEO Richard Baker thinks the value of the real estate is a lot more, telling reporters the company believes the real estate is valued at $7.3 billion, or $40.55 per share.

A recent report from RBC put the value of the real estate at $8 billion, which is a little over $44 per share.

Shares currently trade at $23.36 on the Toronto Stock Exchange. As you can see, there’s a bit of upside opportunity if the value of the real estate is ever unlocked.

Extracting the real estate

Management has been very clear in its plan to monetize the real estate assets. They did so with the sale of the Toronto location in Q1, as well as more recently with the 20 year mortgage on the Saks building.

Management has also been clear it intends to create a REIT at some point with these assets. Not only have they hinted numerous times when talking to reporters, but the company’s newest CFO has experience doing exactly that during his time with Empire Group, owner of Sobeys stores in Canada, as well as the controlling shareholder of Crombie Real Estate Income Trust.

Just how much upside can we expect from such an announcement? Fortunately, Canada’s retail space has a couple examples of companies that have done this before.

On December 6th, 2012, Loblaw Companies announced it was spinning out $7 billion of its real estate into a new REIT called Choice Properties. Here’s how the stock has performed since, compared to the TSX Composite.

Screen Shot 2014-12-10 at 11.57.54 PM

Loblaw’s first surge happened when it announced the plan, the second when the REIT officially traded. Loblaw still retains more than 80% of all the REIT’s shares.

In May of 2013, Canadian Tire Corporation announced a similar plan. Here’s how its stock has done since.

Screen Shot 2014-12-11 at 12.01.17 AM

Both Loblaw and Canadian Tire were up more than 40% a year after the REIT announcement.

There is the danger that HBC’s shares have already gone up in anticipation of this, but I consider those risks small. There were plenty of rumors Canadian Tire was the next to spin-off a REIT after Loblaw did it, and it still saw a nice pop in share price. Remember the old adage: buy on rumor and sell on news.

During the company’s 3rd quarter earnings report last week, management stated they intended to make some sort of announcement about extracting value from its real estate by the end of the fourth quarter. Thus, investors willing to get in and out quickly could be looking at nice gains for just a short period of time. Or, they could sit around and own a retailer which has decent growth prospects and trades at a pretty reasonable valuation.

Either way, HBC is undervalued, and a catalyst is coming. Looks like a good buy to me. Disclosure: I own shares of HBC. 

Tell everyone, yo!