Hudson's Bay's (HBAYF) CEO Gerald Storch on Q3 2016 Results - Earnings Call Transcript

| About: Hudson's Bay (HBAYF)

Hudson's Bay Co (OTCPK:HBAYF) Q3 2016 Earnings Conference Call December 6, 2016 8:30 AM ET

Executives

Elliot Grundmanis - Investor Relations

Richard Baker - Governor and Executive Chairman

Gerald Storch - Chief Executive Officer

Paul Beesley - Chief Financial Officer

Analysts

Sabahat Khan - RBC Capital Markets, LLC.

Wayne Hood - BMO Capital Markets

Vishal Shreedhar - National Bank Financial, Inc.

Oliver Chen - Cowen and Company, LLC.

Mark Petrie - CIBC World Markets

Patricia Baker - Scotiabank

Steven Salz - M Partners Inc.

Christopher Lee - Bank of America Merrill Lynch

Operator

Good day, ladies and gentlemen, and welcome to the Hudson's Bay Company Q3 2016 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, today’s conference call is being recorded.

I would now like to turn the conference over to Elliot Grundmanis. Please go ahead.

Elliot Grundmanis

Good morning, everyone, and thank you for joining us today. On behalf of Hudson's Bay Company, I would like to welcome all of you to our third quarter conference call. With me on the call today are Richard Baker, Governor and Executive Chairman; Gerry Storch, Chief Executive Officer; and Paul Beesley, Chief Financial Officer.

Yesterday we issued a news release on our third quarter results. We also posted complete financial statements to our website and filed them on SEDAR. In a moment I'll pass the call over to Richard, Gerry and Paul to make a few comments on our results, and then we'll open up the call to questions.

Before doing so, allow me to provide a disclaimer regarding forward-looking statements. Certain statements made during this conference call regarding HBC's current and future plans, expectations and intentions, results, levels of activities, performance goals or achievements, or any other future events or developments, including outlook for fiscal 2016 and other statements that are not historical facts, constitute forward-looking statements.

Forward-looking statements are based on current estimates and assumptions made by management in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors that management currently believes are appropriate and reasonable in the circumstances.

However, there can be no assurance that such estimates and assumptions will prove to be correct. Many factors could cause HBC's actual results, levels of activities, performance goals or achievements, or future events or developments to differ materially from those expressed or implied by the forward-looking statements.

For a discussion of these factors, we refer you to the risk factors set forth in the Company's annual information form dated April 28, 2016. As well as HBC's other public filings available on SEDAR at sedar.com and our own website, hbc.com. Listeners should not place undue reliance on forward-looking statements made on this call. Please note that unless otherwise stated all financial figures on this conference call will be expressed in Canadian dollars.

I would now like to pass the call to Richard.

Richard Baker

Thank you, Elliot, and good morning everyone. In the third quarter total sales increased 28% to CAD3.3 billion driven by the addition of HBC Europe. Adjusted EBITDAR was essentially flat compared to the prior following an increase of adjusted EBITDAR of 52% in the third quarter a year ago.

In the current quarter there were lower comparable sales across our banners driven primarily by weakness in the women's apparel, department store and luxury segments. We are navigating this challenging market and continuing to execute our all-channel strategy, which we believe will drive long-term profitable growth. We are making improvements both in stores and online in order to better service our customers and create excitement across our banners and geographies.

To support our strategy, we are not only investing in consumer-facing channels, but also supply chain initiatives. We completed the installation of our world class robotic fulfillment center in Toronto and are already leveraging it to fill Hudson's Bay’s online orders. We believe that there is significant opportunity to grow digital sales in Canada and this technology will help us establish the platform we need to support that growth in a profitable manner.

During the quarter, we continue to make progress on our organic growth strategy in the Netherlands and completed our first major renovation in Germany at our Düsseldorf store. As part of this renovation, we completely remodeled the lower level of the store and introduced the first full-service women's shoe section at this banner. Since the renovation was completed sales in the women's shoe department have more than doubled at this store compared to the same period in the prior year. Over the coming months, we will evaluate the success of this renovation and what truly resonates with the German consumer and incorporate our findings in the renovation of certain of our other stores in Germany.

As always we constantly monitor our capital structure in order to have the most efficient structure possible. During the quarter, we took advantage of a favorable lending environment to reprice our term loan. This repricing is expected to result in annual interest savings of US$2.5 million. Meanwhile, we believe that our world class real estate portfolio continues which is less affected by near-term retail trends, continues to provide substantial value to the Company.

I would now like to pass the call to Gerry who will provide a more detailed update on our retail priorities and initiatives during the quarter.

Gerald Storch

Thank you, Richard. As previously reported sales were challenging during the third quarter, but we believe our strategy is the right long-term strategy for generating future profitable growth. Total Company consolidated comparable sales declined by 3.6% on a constant currency basis primarily driven by weaknesses in the women's apparel, department store and luxury segments.

The decline in retail tourism continues to impact U.S. sales though to a lesser extent than in the prior quarter. The retail environment is dynamic, but we are excited about the opportunities that lie ahead for our diversified retail platform. We are continuing to focus on delighting our customers by building a digital and brick and mortar platform that will allow them to shop whenever, wherever and however they choose.

We remain focused on prudent inventory management during the quarter and despite lower than expected sales, comparable inventory levels decreased by 2% from the prior year. We are well positioned for the holiday season and remain focused on executing our all-channel strategy across our banners and geographies. Our strategy includes initiatives that revolve around finding new ways to allow our customers and offering tailored, exclusive product, which we expect will drive sales across all of our banners. I would like to take a minute to highlight a few from each banner.

At our department store group, we are strengthening outperforming categories such as dresses and active wear while emphasizing top-performing brands and products that are Exclusively Ours. During the past Black Friday, which has traditionally been a U.S. focused event Hudson’s Bay in Canada actually had its largest single sales day in the history of the Company. At Saks Fifth Avenue, we are targeting exclusive and limited distribution product in order to differentiate our offerings.

For the holiday season, Saks has also introduced a new gift concierge service which will offer dedicated gift concierges to assist customers with all of their gift-giving needs. At GALERIA Kaufhof, we are continuing our renovation program to modernize our selling space and introduce new and exciting brands. While renovations at key stores have negatively impacted current sales, these initiatives are expected to drive long-term sales growth across the banner.

As Richard mentioned, since we have completed the renovation of our Düsseldorf store, we have more than doubled sales at our women shoe department compared to the same timeframe last year. We are pleased with this result, but not surprised. While these exciting changes are new to the department store space in Germany, they are based on an established, successful play book from our Hudson’s Bay renovations and turnaround in Canada.

At our Off Price banners, we are refocusing on our core strategy: offering high end brands at everyday value. While Saks OFF 5TH attempted to broaden its appeal by offering a wider selection of price points, the banner's ability to provide high end, sought after products is a major differentiating factor for Saks OFF 5TH as compared to other off priced retailers. Saks OFF 5TH is in the process of re-merchandising its product mix to have a higher concentration of products at the top end of Saks OFF 5TH's offering range, which we expect will drive increased traffic and conversion as well as a higher overall basket size.

Additionally, Saks OFF 5TH introduced a revised pricing strategy which was fully implemented by the end of the third quarter in the prior year. This revised strategy substantially reduced promotional activity and focused on offering great value on an everyday basis. The revised pricing strategy is expected to drive increased margin by offering customers a clearer value proposition.

We are now into the holiday season and while we have a long way to go, we are encouraged by the response of consumers to our offers. We were pleased with Black Friday across our banners. Notably, digital sales growth has been especially strong. All of our associates are working tirelessly to execute the initiatives I described and we are both focused on and excited about the rest of the holiday season.

To further support the growth of our digital business, we are continually improving our fulfillment capabilities and as Richard discussed took a giant leap forward during the quarter with a launch of new robotic technology at our distribution center in Toronto. This technology can fulfill orders 12 to 15 times faster than the manual process we were previously using and allow us to make use of the vertical space in our distribution centers.

We expect to rollout similar technology in our U.S. distribution center in Pottsville, Pennsylvania during 2017 which would serve both the Lord & Taylor and Saks OFF 5TH online businesses. This improved technology will help us increase the speed of our order fulfillment, optimize utilization of space in our distribution centers and reduce expenses associated with our rapidly growing digital sales which as we mentioned grew by 12.9% in our legacy businesses during the third quarter.

As always we are aggressive in exploring other ways to reduce costs and increase efficiencies. While we’ve made considerable progress in this area over the last year, we continue to look for areas in which we can improve efficiencies and reduce our cost structure.

I will now turn the call over to Paul to provide more detail on this and our third quarter financials.

Paul Beesley

Thank you, Gerry, and good morning. Since Richard and Gerry have already mentioned the topline results, I’ll begin by highlighting gross profit which was CAD1.392 billion during the quarter, which is a CAD308 million increase over the prior year’s amount. This increase in gross profit dollars was primarily related to the addition of HBC Europe for part of the quarter. Gross profits as a percentage of retail sales held steady at 42.2% compared to the prior year.

We have continued to focus on prudent inventory management and are pleased with where we ended the quarter on a comparable basis, inventory levels were down approximately 2% from last year which puts us in a much better position for the fourth quarter. This is something we will continue to work on the goal of managing our inventory and working capital as efficiently as possible.

During the quarter, normalized SG&A expenses included a full three months of GALERIA Kaufhof as well as the reduced ownership of joint ventures. The cost structure of GALERIA is such that it has a material impact on our overall SG&A rate. Accordingly, normalized SG&A expenses for the quarter where CAD1.284 billion or 38.9% of retail sales compared to 35.3% in the prior year.

Normalized SG&A expenses as a percentage of retail sales increased primarily due to increased rent expenses incurred in association with the joint ventures and the inclusion of HBC Europe and Gilt as well as lower comparable sales. As Gerry mentioned, we’re continuously looking at ways to operate in a more efficient manner and believe that there are additional opportunities to leverage our scale and to drive improvements in our cost structures beyond what we’ve already accomplished over the past year.

Adjusted EBITDAR for the third quarter was CAD276 million compared to CAD280 million in the prior year. Adjusted EBITDAR as a percentage of retail sales declined 250 basis points to 8.4% largely driven by lowered comp sales. Adjusted EBITDA was CAD89 million during the quarter compared to CAD170 million in the prior year. This decline follows a 44% increase in last year’s adjusted EBITDAR in part due to increased expenses associated with the joint ventures.

The joint ventures had a CAD60 million impact which was expected on adjusted EBITDA during the quarter compared to an CAD18 million impact during the prior year. Commencing with the fourth quarter the Company expense that its results will be more comparable as it anniversaries the increase in joint venture rent expenses associated with the contribution of its European properties and third-party equity sales. These joint venture expenses are essentially flat over the course of the year while the retail business is seasonal, with sales and earnings weighted toward the back end of the fiscal year.

Finance costs were CAD48 million compared to CAD29 million in the prior year. Of the CAD19 million increase, CAD8 million was due to changes in non-cash finance income generated from mark-to-market adjustments associated with the valuation of outstanding common share warrants and CAD6 million was related to higher interest expense associated with finance leases and pension liabilities acquired as part of the GALERIA Kaufhof transaction.

Finally, net loss was CAD125 million during the quarter compared to income of CAD7 million during the third quarter of fiscal 2015. Prior year earnings included a net gain of CAD91 million related to the creation of the joint ventures compared to CAD3 million in the current year.

Our normalized net loss in the period was a CAD102 million compared to a loss of CAD1 million in the prior year. This change was primarily a result of increased rent expenses to both the joint ventures and third parties, mainly driven by the acquisition of GALERIA Kaufhof and its real estate portfolio. Higher depreciation and amortization expenses, lower comparable sales and increased finance costs.

Based upon our performance to-date and our current expectations that we will achieve flat low single-digit comparable sales growth during the remainder of the year, we are confirming our previously updated guidance. On this note, I would like to remind everyone that we first provided guidance back in 2015 as a way to provide the market with an understanding of HBC as a whole, following the transformative changes to the Company as a result of creation of the joint ventures in our acquisition of GALERIA Kaufhof.

During the current quarter capital expenditures net of landlord incentives totaled CAD153 million compared to CAD141 million in the prior year’s period. HBC's initiatives during the quarter included the opening of 12 Saks OFF 5TH stores in the U.S. and five OFF 5TH stores in Canada. Additionally, the Company opened Saks Fifth Avenue stores at Brookfield Place in Manhattan and Honolulu Hawaii.

Additionally, the Company completed the installation of its robotic fulfillment technology at its Toronto distribution center and wrapped up the first stage of renovations at its GALERIA Kaufhof store in Düsseldorf. We are also continuing on the major renovation at the Saks [flagship] store in Fifth Avenue in New York.

We continue to expect total capital investment net of landlord incentives in fiscal 2016 to be between CAD700 million and CAD750 million with approximately 70% of this related to growth initiatives. Please see our third quarter MD&A for a full breakdown of our outlook including material assumptions and risk factors.

I'll turn the call back to Richard.

Richard Baker

Thank you, Paul. Despite the challenges we are seeing in the retail apparel environment we remain focused on executing our long-term strategy for profitable growth and are taking steps to ensure that HBC is in a position to capitalize on the many opportunities that we have. As always, I would like to thank all of our associates for their hard work so far this year and also like to wish everyone a happy holiday.

Operator, we are now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Sabahat Khan of RBC Capital Markets. Your line is now open.

Sabahat Khan

Thanks. You provided a little bit of color earlier on the trends to date. Is there any indication of how the comps are trending versus what you saw in Q4, if there's a number you can share or just sequentially?

Gerald Storch

We really can't, but obviously you can see that we feel that there is no reason to think that Q4 should be a mirror image of Q3.

Sabahat Khan

Okay. And then just on the Saks Fifth Avenue, just on the full-line banner, I'm just wondering, like over the last year or two there's been some impact from lower traffic from East Asia or international consumers. But recently we've noted that some of the luxury product companies are seeing more consumption within China because of some tax change and things like that. Is there a possibility that there's been a shift in how kind of the international consumer is purchasing luxury and some of that may not be coming back?

Gerald Storch

It’s certainly possible, but we're also reaching a point where as time goes forward it becomes less and less relevant as we see growth with our domestic consumer and the international base declining each year. So we watch it very carefully. And as we mentioned in our remarks, it was a factor, but it was less of a factor in the third quarter than it had been in the past and so one way or the other it’s going to decline as a factor. Either some of them are coming back or it's ground down so low that it doesn't matter anymore.

Sabahat Khan

Okay. And then just lastly, on Canada, can you maybe talk about the trends you're seeing in Canada at Saks, as well as maybe in Hudson's Bay just in terms of Q4 and how that's trending, given that there's new competition in the space here.

Gerald Storch

Yes. Again, I want to be careful in Q4 because we're only partway through that, but I will tell you that, again in Canada we’re quite pleased with our performance there and we mentioned that Hudson Bay had a largest day in its history on Black Friday and exchange rates there having the opposite effect that they're having in the U.S. because Canadians with the exchange [inaudible] tend to stay in Canada.

So we felt that our business in Canada as you know at Hudson’s Bay is one of the most successful stories in the department store industry certainly in the last decade and it continues to be a great success story. The Saks and Saks OFF 5TH entries into Canada have both been very successful on all measures and we're quite pleased with that.

Sabahat Khan

All right. Thank you.

Operator

Thank you. And our next question comes from Wayne Hood of BMO Capital. Your line is now open.

Wayne Hood

Yes. Good morning. I just wanted to come back to your comparable store inventories which you said were down 2% in aggregate. Can you peel back that onion a little bit to see, or give us some sense of where the comp store inventory is by banner, especially around Saks where you have more fashion risk, and where you think that inventory will be at the end of the year overall?

Gerald Storch

Wayne, I'll answer that question subjectively and see if Paul has any more quantitative color to put on it, but we have been tremendously focused on cutting inventories and we’ve talked about that all year, and again in Q3 even though we were disappointed in sales, you can see that our inventories came in below last year on a comp store basis.

You can believe just for the reason that you gave that we have been laser focused on the Saks Fifth Avenue inventories and we have planned the inventories at a trend that is far worse than what we think the sales will come in at and so we are committed and over and over again when you take a look at that business it's very clear.

If you do the overage, underage analysis it's much better to run out than it is to have left over. And so we said, well, if we start running low, we’ll chase, but we've been very, very aggressive there and so it's something I'm not worried about.

Wayne Hood

Okay. And then my last question would be, if you had to dial back 2017 capital spending because we stay in this period of really no growth which growth initiatives would be most impacted, would it be new stores, remodels, Europe and could you dial it back to CAD500 million which is basically looks like the core underlying rate and leave the CAD200 million or so as kind of discretionary?

Gerald Storch

We could dial it back and in fact we look at it everyday and I don’t know if Richard or Paul give more color on that, but we clearly are focused on maintaining the investment in digital given how important that growth is and the significant growth that we continue to see to this moment and so we continue to focus on that. And then there are certain projects that are more strategic than others. And it's kind of obvious when you look at them for us anyway which ones are the big stores or the foundational strategy changes and those will continue, but others we can pare back. Richard, if you want…

Richard Baker

As Gerry said, we look at this all the time. We tend to pare back across the board and on the edges. So we delay things, we do more testing, give projects that like the expansion of a shoe floor in Germany, we might let it age longer and then rollout more of those particular variations in a later period of time. So we have lots of room to modify our capital spending without dramatically changing our strategy.

Paul Beesley

Okay. The final takeaway is that as the management team we’re very focused on this and we're very mindful of the amount of CapEx relative to how the business is doing. And so I guess the key message is that we're going to be responsive to the current business climate and act and behave accordingly.

Wayne Hood

All right. Thank you.

Operator

Thank you. And our next question comes from Vishal Shreedhar of National Bank. Your line is now open.

Vishal Shreedhar

Thanks. Few quick ones here. Earlier in the year management indicated that free cash flow would be flattish, just hoping to get an update on that?

Paul Beesley

Clearly, earlier in the year we're guiding to a higher number. So as we’ve seen the declines in EBITDA that clearly is going to affect our cash flow and you've seen a stake down capital in the current year. Further you’ve seen us focus a lot of attention on inventory and so we're coming out of the quarter and a good inventory position. So I think those are the puts and takes that you need to think though.

Vishal Shreedhar

Okay. So if I go through those puts and takes and I look at the changes in CapEx and the changes in the EBITDA and if there is negative free cash flow then would management just take up that temporarily or would you look for asset sales to compensate?

Paul Beesley

We certainly have ample capacity on our ABL, so in terms of funding the company we’re actually in a very good position and I think that's demonstrated by the renegotiation of the rate on our term loan facility. We reduced cost of that by 50 basis points through the quarter which I think is a vote of confidence.

Gerald Storch

I would add just conceptually if EBITDA is less than we expected then we push ourselves very hard to make up for that on a cash flow basis with working capital and capital cuts and so we've been focused on that balance.

Paul Beesley

And then also recall we have other opportunities such as what we demonstrated with the transaction around Short Hills and the [lease] [ph] in Hawaii whereby we were able to generate CAD100 million of cash from [indiscernible] to the landlord and renegotiation with some of the terms in Hawaii. So in a sense no one would have that in the model and that’s additional cash on the business.

Vishal Shreedhar

Okay. Just a quick housekeeping question here. I believe earlier in the year with the prior CapEx guidance 750 to 850, the indication was that 70% of that was growth, 30% of that was maintenance. With a new CapEx guidance 700 to 750 is that mix 70/30 still apply?

Paul Beesley

Yes. It would be still in the range.

Vishal Shreedhar

Okay. So that maintenance CapEx which is now gone lower that's just deferred for a couple of months, is that the way we should think about it?

Paul Beesley

Yes. That’s fair.

Vishal Shreedhar

Okay. Thank you.

Operator

Thank you. And our next question comes from Oliver Chen of Cowen and Company. Your line is now open.

Oliver Chen

Hi, thank you. We had a question about modeling the gross margin rate going forward as you anniversary from the changes you've made it off that. How should we think about that line item and can you brief us on the outlook for merchandise margin. It seems like you've been really proactive about making sure inventories in the right place now and what kind of opportunities or headwinds have you seen on the merchandise margin line.

And then secondly, just on the topic of tourism, when do you think going forward that some of the comparison is and some of the pressure that we're having or where are we in kind of the new normal as the dollar continues to trend stronger and highly volatile as well? Thank you.

Gerald Storch

Yes. I would just say in general Oliver a lot of the comparisons for our Company going to be far easier for everyone when we get through this fourth quarter because we'll have had ownership of the same companies for the same period, we'll have the JV’s in a fairly a like-for-like basis year-over-year.

So in the tourism as I mentioned earlier is starting to become less of a factor because of both it's somewhat stabilizing but also because it's a lower percentage of the business now. So I think as you get to the fourth quarter and then into the first quarter of last year, which will be truly comparable because then we'll have owned everything including Gilt for the comparable period, then a lot of this complexity goes away.

I want to remind you that both on the sales and the expense line we have this situation where Kaufhof is a materially different profit formula where the gross margin rate is higher and the expense rate is much higher. So it maybe looks like we're a little better on gross margin than we are and it makes look like where we are worse on SG&A than we are you know and we feel we're doing a great job in discipline on both of them though in this environment.

Operator

Thank you. And our next question comes from Mark Petrie of CIBC. Your line is now open.

Mark Petrie

Yes, good morning. You spoke about the strength in the Canadian business earlier, but I want to ask about the deceleration in the DSG Group overall. And I know you don't want to necessarily get into talking about specific banners, but it does have an implication for what's going on at Lord & Taylor. And I was wondering if you could just talk a little bit about the trends at Lord & Taylor in Q3 and then what you think will turnaround in Q4?

Richard Baker

So it's Richard speaking. So we've done a tremendous amount of analysis comparing Lord & Taylor which represents about 12% of our total sales to our competitors in the region. Are we doing something wrong? Are we missing something? What is going on? And all of the analysis that we brought back is actually that when you compare Lord & Taylor to other similar like businesses in the northeast by category.

The Lord & Taylor is actually performing exactly the same way as its peers or slightly better. Some disadvantages Lord & Taylor has is that it's in the northeast and we're finding that from talking to our peers that sales in the northeast are maybe 4% or so lower weaker than other – than the balance of the United States.

Lord & Taylor also doesn't have home which we're working on different strategies in order to institute home at Lord & Taylor. Home right now is a very strong category as people cycle their investments into reinvesting in their homes and when you analyze sales that competitors, the home is a larger growth area.

So when you analyze category by category Lord & Taylor is performing well we think the team has a good strategy for going forward with more unique product and more private label and higher service and some better brands and more differentiation. Also we're spending a little bit more on marketing that business which we think is also a strong point.

Lastly, at Lord & Taylor we really pushed ourselves to focus on dresses which is a unique business that Lord & Taylor is a leader in and when a customer comes in to buy dresses at the department store that’s the leader in that category they inevitably buy shoes and handbags and other categories and we think that strategy that we turned to has recently is going to create a good trend for us.

Gerald Storch

One other point related to that, and consistent with that, of all of our banners and again Lord & Taylor is about 12% of our business, but all of our banners we feel Lord & Taylor is the most sensitive to weather. And I hate to use that or raise that, but every retailer in the universe has raised that given what's been going on with the weather over the last 12 months.

And so the third quarter if you recall, and going back to August, the start of the third quarter was August, September and October the quarter we're talking about today was especially troubled from the weather standpoint especially in September, and so Lord & Taylor is a pure play version of the women's apparel business and so particularly subject to that.

We look with sort of some optimism towards the coming weekend which will be the coldest weekend in the Northeast in two years as the weather finally actually going to be cold here going up. So we’ll see if all those stories about the weather are true or not, we certainly have the best litmus test in Lord & Taylor and I think so – so we have to view that in that light.

Mark Petrie

Okay. That's very helpful. And is that weakness in the Northeast consistent across your other U.S. businesses?

Richard Baker

So from the work that we've done across the industry, we believe both our banners and other people's banners that there is a weakness in the Northeast. And again, part of that is the high concentration of tourist locations like Manhattan in the Northeast, but it's a variety of reasons.

Gerald Storch

Again, I believe that would be true for Saks OFF 5TH. Saks and the luxury business is its own world and I don't think it's just weather affected. As I mentioned Lord & Taylor’s especially affected by the weather. I don't see Saks as being – Saks Fifth Avenue full line as being affected by that as much as by tourism and the timing of the sale breaks and whole bunch of other factors that affect sales.

Richard Baker

Additionally, I think the Northeast maybe is not all weather, it might have to do with the financial jobs and it might also have to do with as I said earlier tourism. There are other things going on in the Northeast that are making sales a little weaker than they are in the balance of the country.

Mark Petrie

Right. Okay, that’s helpful. Thanks. And then I wanted to ask a broader question about, again sort of back to this whole topic of the rent burdens and the sort of structure at HBC and understanding that you own a large percentage of the property as landlords. Is there a threshold on rent as a percentage of EBITDA where you would look to take action in terms of that rent burden or how do you look at that or how do you think investors should look at that.

Paul Beesley

It’s Paul. I look at the impact of rent as a percent of sales and quite comfortable with where we are. We call that a significant portion of the rent does come back to the Company, courtesy of the ownership structure. We own about 84% of the RioCan joint venture and 64% of HBS, so we’ve discussed this in the past and our current rent burden is something that I’d be very comfortable with.

Gerald Storch

Another thought there is just we've done this proactively and it's what a lot of activists and others are sort of screaming at other retailers to do. And the idea is to make clear or one of the goals is to make clear the value of that underlying real estate and obviously if we do that then there is going to be this extra rent load towards the retail business. But there should also be a clarity and a value put on the real estate as a consequence and so we expect our – I won’t tell you how to value our Company, but if you do some of the parts then the real estate value should be carrying a bigger part of the load because we've – transferred that rent over to the real estate side.

And so that's what we expect to see, it should make our stock more stable not less which seems to be happening to some degree at least at the moment is that people tend to look at the retail side and forget about the whole real estate thing and say, oh my god look what happened to EBITDA when this is all planned. This is the entire strategy and you have to look towards both, the retail side and the properties which are now more valuable in order to value of the Company.

Richard Baker

Additionally, this will be the last quarter before they're then comp again, so we have the same questions over and over, it gets confusing every time, but of course we acquired the real estate portfolio from Germany about a year ago, so all of these rents obviously we would totally modeled and this is occurring just the way we expected it to occur.

Mark Petrie

Okay. Thank you. That's helpful.

Richard Baker

I guess the only other thing to add is that keep in mind that in the smaller quarter like the third quarter then the rents will play a bigger role because the rents are flat across the year in a quarter like the fourth quarter where we're going to have – where you have obviously as a retailer a lot more sales and a lot more EBITDAR right, then the rents effect on EBITDAR and net earnings as a percentage goes way down.

Operator

Thank you. And our next question comes from Patricia Baker of Scotiabank. Your line is now open.

Patricia Baker

Thank you very much. I actually have two questions. I just want to come back to trends in Q4 and what you're seeing and I understand that you're not going to give us the November sales rather which would be very nice to give us an indication. I appreciate the color you gave on Black Friday. Can you talk about – are there particular categories that are performing particularly well? Where did you see the strengths in Black Friday?

And then related to that there's a lot of commentary as there is every year about how the holiday season shaping up et cetera, et cetera. Are you – what you are hearing in reading out there isn't any different than what you're seeing or is it is what you're seeing pretty consistent with what we're reading in the papers?

Gerald Storch

Well, let me do with the last part first. I am always – I am constantly confounded by where I read a newspaper about retail trends and I think it must be because they don't have real data which is a huge disadvantage as a reporter when you're trying to say what's happening. But for example, let's take the Black Friday weekend, right. I have read over and over again, the Black Friday is diminishing in importance in the U.S. and that sales were down over the holiday weekend in bricks and mortar and they were only up on the Internet.

I personally believe that's totally wrong. That is not true. Nor was it true last year or the year before that. All the evidence I’ve seen from multiple retailers and I've worked in multiple retailers, I’ve worked as a consultant before coming here and – are that Black Friday is only growing in importance not decreasing. And you go – well how can all those articles be wrong. Well they rely very heavily for example on a survey that’s done by the National Retail Federation each year where it simply asked people how much you just spend and how much do you plan on spending.

No consumer can tell you what they spent over the weekend. It's an absurd question. When you actually look at real data like for the Internet and Adobe data, you will see that the market grew by double-digits on the Internet over Black Friday weekend and Cyber Monday. And we've already told you we grew by double-digits even in the third quarter and on the Internet and over a holiday period the Internet tends to be more important not less. So you can sort of reduce maybe how we're doing there. And again I mentioned in my comments that that our Internet sales are quite strong. So I don't know what they're talking about on the Internet, now I can accept that it was great.

Now we move to the bricks and mortar, and a lot of them said oh my god there was no one in the stores all this. A large part of it is confusion where people are saying Black Friday is less, but they're not adding in Thursday where a lot of stores are opening on Thursday now in the U.S., on Thursday evening.

For Black Friday, you have to add the both together obviously because you open on Thursday evening you don't get a second rush when you open on Friday morning because you already had your grand opening for the Black Friday weekend, but you put it together and most retailers I know have actually have done quite well on Black Friday. And data that we've seen from credit card companies and others seem to indicate the Black Friday was up in the U.S. both in stores and online, not just online as was broadly reported.

So I think that a lot of what you read there is reporters grasping to write a story, but not having the facts to write the story. They only have what they can have and they're not writing the right story. That simple and I really believe that in this regard. You had people coming out on television saying they had great Black Friday from big retailers and you heard us say we're pleased with our results on Black Friday. So I think that's only stronger than ever. People love the value. That's inherent it.

Now as for the rest of the season what we've seen year-after-year is a lull after Cyber Monday and then the race to Christmas. It is also my opinion. Not true [is celebrated that] somehow sales are happening earlier. It's very clear to me that sales are happening later and closer to Christmas in most retail categories in the United States.

And this year with an extra two days between Black Friday and Christmas there will be even later because people are thinking I’ve got another weekend when all they really have is another Friday and Saturday, but still that's a lot, an extra Friday which will be a holiday for a lot of people and an extra Saturday to Christmas Eve Day, which is open in the U.S. will be big opportunity for those who are procrastinators and the survey data for what it’s worth says that people are later in their shopping this year and they've been in prior year.

So I would expect it to come late and strong for this holiday season given the calendar and the extra days until Christmas. So that's the pattern one would expect. And then of course, it’s been widely written that the first part in November was stressed by the election which should always is and then by the outcome which I think caused more consternation or confusion than previous outcomes of cost.

But Black Friday once we got there it looks like people said oh I know Christmas is coming now and they came out to play. So that's what happened in the market overall without getting too much into our results any more than what I've said. As far as strong categories, overall we've mentioned already that that active wear continues on a just to be incredibly strong overall.

I would say a weaker categories women's handbags particularly at the department store level that is the DSG level where a lot of these brands have been pulling back on promotion and also may have been overexposed which is why they're pulling back on distribution as well and that's affected that market quite significantly it does not you know that's been a stressful area overall.

It does look like women's ready to wear might be starting to come back and again I want to see what happens over this colder weekend before making a holiday call based on that. So the other thing that's always been stronger in [indiscernible] women where men's wear has been one of the categories you can sort of start to count on for some growth.

Richard Baker

Just also to add the beauty of the department store concept is that we are able to shrink businesses that get weak or that are in a cyclical weakness and we can grow businesses that are getting strong. So for example, if handbags are getting weak or a certain particular brand and women's apparel is getting weak, things like athleisure are growing and we're allocating more the square footage in our stores athleisure. Men's shoes is a very hot category and we are allocating more space in our stores to men shoes.

At Lord & Taylor for example in order to make those stores more profitable and more efficient we are rolling out testing in certain stores a home component, which will allow us to create bring in a new category, bring in traffic and drive greater productivity out of the store. That is the beauty of the department store model, which is what has attracted us to this business in the first place and continues to attract us to the business. A vertical like teen retailer has a very hard time when their category is weak. They have a very hard time bringing in other categories in order to fulfill their volume opportunities.

Gerald Storch

And in fact, it's so obvious I forgot to say it but one of the biggest you know one of the better categories is home overall, much better than apparel. That’s not true just true for us. It’s true economy wide as we’ve seen - I think the MasterCard market research expert who is very well-known for reading the trends and of course they have real data too, which I love. She says apparel was down everywhere except down under in other words. Apparel sales are stressed globally except for Australia for some reason but down everywhere.

But home there's been a shift from apparel to home goods. Again this is not - I've been unfortunately or fortunately have been in this business for 30 years. This isn't the first time and so far it's always come back and people always say each time that oh my gosh maybe it's a permanent shift and people aren't going to do it anymore, but they aren’t going to buy apparel, but then it’s always has come back before and so I strongly believe it will come back again.

So but clearly home is stronger and in Hudson Bay we have a very strong and great home area and we have that in Kaufhof as well and Europe so we benefit from that. In our North American stores by and large we don't have home offerings. As Richard mentioned we’re exploring ways of adding them using technology, using the Internet combined with a physical guide shop so we can start bringing home in order to make sure that the stores are more exciting and interesting in playing into that trend.

Patricia Baker

Okay. That’s very helpful. My second question is around the efficiencies you talked about them but that's a big focus and that there were some achievements in 2016 and some achievements in the third quarter and that you're going to do a lot more? Can you just talk about where you’ve driven efficiencies number one? And then number two maybe give us some timelines and guardrails of what we should be looking for over the course of the next 12 months to sort of determine that you’re meeting the goals there?

Gerald Storch

Well, the first thing I want to assure you of is that we have exceeded and in most cases surpassed any number that we've given you in the past. So for example, the CAD100 million of synergies with the Saks acquisition or the CAD75 million of cost reduction that we've achieved over the last year across our business through our cost reduction effort.

And the reason you are seeing that the expense rate rise in the third quarter in particular is there are two main factors, one is the addition to Kaufhof at a much higher expense rate than the rest of our business. And then the deleveraging effect, the fact we had lower than expected and negative sales growth, so those both came into play overall.

And then you have to include the JV rents when you take a look at the expense rate and it just – which again we've been through many times here, but the JV rents are the vast or the significant majority of the change in year-over-year EBITDA is coming from the JV rent, so you have to put that as well in the expense rate. It doesn't just because we've achieved the goals that we have articulated don't mean that we don't see that the SG&A is a major opportunity for us going forward and so we have every intention of continuing to go after that.

Already just in the first three quarters of 2016, we announced in Europe a voluntary restructuring program where associates could take early retirement and that amounted to approximately CAD30 million during the 39-week period that ended with the end of the third quarter, and we expect annualized savings from that to be about CAD16 million a year. Additionally, we continue to go after back office efficiencies and look for more ways to gather those because we want to focus on non-customer facing efficiencies.

Our fundamental hypothesis is that customers love great department stores and that includes great service. We do not want to – in the short-term pursuit of SG&A reduction, we don't want to destroy our competitive advantage versus the Internet which is the service we provide in the stores.

And I think some retailers are in great jeopardy of doing that so they can have a great quarterly conference call, but in the end they’ll find that they gave away the crown jewel which is the fact that customers when you ask them why do you shop in store instead of the Internet they go because they like the service and they like to be able to try things on and it’s really hard to try things on if you don't have the right attendants for the fitting room, et cetera. So we're focused heavily on the back office to see where you can get more back office savings.

And then obviously we mentioned what we're doing on the Internet. It's very important that we focus on the cost structure of the Internet and continue to lower the cost, the variable cost in particular of Internet operations because it's still very expensive to pick and pack an item and send it and to do the photography and do the work there. So that's why we've had so much focus on the front-end of automating items set up which we're well on the way towards doing, so that we reduce the cost per item so that gives us the ability to have more items on the Internet as well.

And then on the backend with DC automation and as we talked, Richard talked and I talked about the automation of the Scarborough Internet fulfillment center. And this is absolutely vital, so that we can continue to grow that business that the kind of double-digits we have in the past and even more and do that in a cost structure that makes good economic sense if we go forward.

So we did that in Canada already because, of course, we view Hudson Bay as the – we love our children equally, but Hudson Bay is the sweet spot of our business. So we've did that there first and then we’ll be bringing that to the United States for other matters next year and beyond.

Richard Baker

Also let me just add, we create tremendous efficiencies when we do things like going to the Netherlands and open up 20 new stores. Those 20 new stores are going to get managed and plugged into the infrastructure of Kaufhof in Cologne. So without having to lose any human resources, we actually become much, much more efficient by having the existing team do the buying and planning and be the backbone of operating those stores. So that's a huge advantage for us in Germany, it’s kind of like you can think of it is a big synergies, but it's through growth.

Gerald Storch

And right now for the Netherlands entry, obviously we don’t have stores open yet, so all we can do is have expense and so we're working – we want to make these openings fantastic and just had a meeting yesterday on what the service is going to be like in the stores and I can promise you we're going to open with the best service anyone's ever seen anywhere. We are going to stand for that when we enter the Netherlands and everyone's going to know they're seeing something that never seen before in that entry.

So we are very focused on making a success there as Richard pointed out, think about adding that much volume with a marginal cost structure and so the full cost structure because we're able to leverage the headquarters in Cologne which is only two hours away by the way from Amsterdam.

Patricia Baker

Absolutely, I look forward to hear much. Want to remind us of the timeline for those Netherlands stores?

Richard Baker

The first stores will begin to open in August, this coming August and we'll open up over a 24-month period. We're making very good progress and we're on schedule.

Patricia Baker

Thank you, Richard.

Operator

Thank you. And our next question comes from Steven Salz of M Partners. Your line is now open.

Steven Salz

Hi guys, just a follow-up on the joint venture, so I guess given increasing likelihood or probability of a rate hike. There were just increasing REIT’s generally and then the impact on things like REIT’s as you're thinking changed at all of the original timelines you slated in early 2015 for doing something public with the joint ventures?

Richard Baker

Our timeline has not changed. We continue to be very focused on creating value through our real estate and the increasing interest rates are no surprise to us and the arbitrage that exists between cash flow – from a real estate and cash flow from OPCO obviously the spread continues even if the cap rates go up and a changing environment actually creates more opportunities for us to acquire things efficiently and with good value opportunity, so nothing is changed for the time being.

Steven Salz

Thanks.

Operator

Thank you. And our next question comes from Chris Lee of Bank of America. Your line is now open.

Christopher Lee

Good morning, guys. Thanks for taking my questions. Just have a few quick ones hopefully. First, I guess Gerry you mentioned about the cost reduction opportunities to CAD60 million from the voluntary restructuring program in Europe and also the back office efficiency of CAD7 million. Can you just help us out in terms of the timeline of when those savings would actually be realized starting in Q1 of next year or would have been Q4?

Gerald Storch

They are starting already and I just want to emphasize part, what I said we're not prepared to get specific numbers out. We are not stopped on this and a big part of our entire investment hypothesis is we can buy these banners both in the U.S., North America and beyond and get synergies in the backend and savings and we have much more to come, so we're working very hard on identifying that and capturing that and we'll tell you more about that as we go forward. But the ones that I talked about are already realized on run rate that are already in our numbers.

And again I just want to emphasize how much – I know how hard just to analyze the SG&A in this Company right now. And fortunately that will get more comparable in coming quarters and right now we're just dealing with the combination of the joint ventures and the Kaufhof much higher expense rate which is disguising. What I really believe is a very strong effort by the team on cost reduction.

Christopher Lee

Right. And I agree. And I think this is my second question, I agree this is going to be a lot more useful as you said in Q4 you anniversary a lot of these comparisons with the JV's in Europe. And so my other question is if I look at your – if I take the low end of your 2016 guidance and if I do my math right and this obviously have not, but if I take the low end of your guidance I mean it would seem that for Q4 of this year you are essentially expecting adjusted EBITDAR or EBITDA to be up low single-digit and for the margin to be roughly stable compared to last year. Is that – am I thinking of this the right way?

Gerald Storch

I think that's reasonable, Chris.

Paul Beesley

Again I just want to emphasis so much because I think it's important to say this. I think taking the Q3 which is relatively small quarter and we are up pretty dramatically last year and with all the trends going over – if you take Q3 and try to protect at that those trends in Q4 we are going to make a model here. If you think Q4 is being more comparable and also the holiday season, the different environment from what we saw in Q3.

Gerald Storch

In Q4 is when the department store shine that's our quarter.

Christopher Lee

Yes. That makes sense. And Richard, just a quick question, follow-up on the real estate strategy. I think in the past, you have mentioned certain criteria that you would look at before deciding to do an IPO of the REIT. And I think – I remember one of those things you mentioned was you need some diversification away from just HBC properties, you need some non-HBC properties. Is that still kind of one of the criteria you need to see before there's anything with the JV’s?

Richard Baker

Actually as the worlds evolve, the need to diversify the credit is really much smaller than it used to be. So a public offering could be done without any diversification of credit and it could be done immediately. So that is not a driving force, I think we could create more value with diversification, but that's not a driving force. I think what we originally - when we originally launched our joint ventures, I think one of the concepts that we describe was that this would be a lumpy growth process and I think it's proven to be that.

So we started out with the group of properties then we acquired the German portfolio and the real estate company that was a huge lumpy transaction. And I think rather than seeing a stream of small transactions and a stream of small activity you'll see more large volume type of transactions that will allow us to create value.

Christopher Lee

Okay. And my last question maybe for Paul just on Gilt I remember when you guys acquired the property almost a year-ago, you’ve given some financial guidance about I think contribution to sales for F2016 to be about CAD500 million and adjusted EBITDA of about CAD40 million by - through F2017. Are these still could guide post to use or has the business kind of changed that, that these are no longer numbers that we should be using?

Paul Beesley

I think they are close. Sales I think would be a little more challenged, but clearly we’re reluctant to provide specific banner guidance that’s what I would say Chris.

Gerald Storch

We're excited about Gilt. And the brand is incredible and I always tell the story, anywhere I go, if I meet someone new and I say who I work for if it’s in Canada they love Hudson Bay and that gets them really excited. In the U.S., they don't know who Hudson Bay is, they get excited about Saks Fifth Avenue at first and then I mentioned we owned Gilt and they get absolutely wild, people love Gilt so much and so the potential there is quite significant.

We need to get the integration farther along with Saks OFF 5TH before we get the benefits or most of the benefits that we're looking for there and because of some technological barriers it's going to take us a couple more quarters until we accomplish what we're trying to accomplish, so those businesses are totally integrated and that's when we'll be able to give you a better read on how that transpires, meanwhile the technology that Gilt has provided and the capabilities that provided are being used already company-wide.

So as an example, we're launching a new mobile site, new app and for Kaufhof and that was designed and constructed in Dublin, Ireland by our Gilt team for our German business and most of the front end now of our websites are being engineered by the former Gilt people.

So the value of the acquisition was far beyond sort of the sales that are provided a much more I believe about providing the Internet savviness and skills in the – that help to accelerate that. And as I mentioned, we are seeing great digital growth in our business as a whole. Analogize that to Wal-Mart’s multi-billion dollar purchase of Jet.com, essentially get that same DNA infused into their business.

Richard Baker

In a sense we bought a technology company that was expert in front end for retail online.

Christopher Lee

Great. Okay. Thanks for your answers and happy holiday. Thanks.

Richard Baker

Thank you.

End of Q&A

Operator

Thank you.

Richard Baker

Okay. Thank you all for joining us today. Happy holidays.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Have a great day everyone.

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