Hudson's Bay Lord & Taylor Transition Highlights Department Store Crunch

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About: Hudson's Bay Company (HBAYF), Includes: JCP, JWN, M, MAC, SHLDQ, SPG, TCO
by: Anne Anderson, CFA
Summary

Startling decision to sell Lord & Taylor to Le Tote sketches out a new market for malls to rent instead of sell apparel.

Look-back at last few years of department store operating trends shows shocking magnitude of decline.

Retail REITs have real estate exposure, but not earnings exposure to department store bankruptcies.

REIT investors should see upside, as Simon Property Group, Macerich and Taubman Centers look like deep value Buys.

Department store investors should ponder the trends and consider which retailers to sell before more bankruptcies are announced.

Introduction

Hudson's Bay Company's (OTCPK:HBAYF) decision to unload its struggling US department store Lord & Taylor for only $100 million to online apparel renter Le Tote should startle investors. While the price may cause this divestiture to appear to be an acknowledgement of another department store failure, the new concept presents an idea for bringing a fast-growing online business as a new tenant to US malls. Looking back at the last few years of department store operating trends, investors should understand the magnitude of decline in total department stores and comp-store sales. Be prepared to see more additions to the list of department store bankruptcies. There are still Sells in this category of retail stocks.

Despite the loss of anchor tenants, Retail REITs, including Simon Property Group (SPG), Macerich (MAC) and Taubman Centers (TCO), have limited exposure. Rental contribution from department store tenants is minimal. Mall tenants drive consumer demand, and the rapid pace of mall retailer adoption of the emerging apparel rental market proves it. Investors should be looking to Buy Retail REITs while the news on the department stores is worst, in order to enter at the lowest probable price and for high current yield.

Divesting Lord & Taylor as an Apparel Rental Experiment

Last week, on August 28, 2019, Hudson's Bay Company announced plans to sell Lord & Taylor to clothing rental subscription service Le Tote for only $100 million, read the press release here. The deal reveals not just a massive financial loss on the $1.2 billion price tag in October 2006 when Federated sold Lord & Taylor to NRDC Equity Partners (the private equity firm that merged with then-privately held Hudson's Bay in July 2008), but also a carefully supportive agreement that ensures venture stage Le Tote may capture US market share over a period of several years. Le Tote will assume ownership and operations of 38 Lord & Taylor stores, as well as its digital channels and its inventory, in exchange for $75 million in cash and the balance of $25 million in a note payable in 2 years. Hudson's Bay will retain ownership of Lord & Taylor's real estate, and may begin to "reassess and redevelop" Lord & Taylor locations starting in 2021. In the meantime, Hudson's Bay will continue to make rental payments to US landlords of $58 million annually for at least the first 3 years of the new relationship.

What does this mean for Hudson's Bay Company? Executive Chairman Richard Baker has been divesting international assets to concentrate remaining investment in Hudson's Bay's 300 department stores and specialty stores in Canada. He is also attempting to take Hudson's Bay private, although unable so far to complete his June 2019 takeover offer of $7.12 per share for the 33% of the stock not held by his shareholder group, while he fends off a "mini-tender" for 10% of Hudson's Bay shares from Catalyst Capital Group at a higher price (read about it here).

Le Tote founder, Brett Northart, expects to "personalize the Lord & Taylor shopping experience" and expand to new "smaller format stores" outside the northeast and Mid-Atlantic markets where Lord & Taylor is found today. He expects to "re-purpose" stores that no longer appear to be in good locations.

What an understatement. Lord & Taylor sold $1.4 billion of traditional and fashion apparel, managed like any other department store, i.e., with departments for make-up, shoes, coats and outerwear all separate from accessories and each of many categories of apparel. In contrast, Le Tote puts it all together for their customers, relying on stylist selection to assemble rental packages for each customer for a "subscription service" priced at $49-79 per month.

This deal says to me that the retail apparel business is coming apart, now floating free from marked-down inventory hanging on racks in mall stores to packages selected online from photo images and shipped for free. That specific dress or certain pair of jeans we used to hunt for is now just as likely to be found sitting in a warehouse or tossing about in a washing machine as to be waiting for us to find it at the mall. Yes, you can give it back to your rental service, and they wash it before sending it on to their next "subscriber." Yes, you can keep it if you decide to. No, you still have to pay for the next month's packages, and they keep sending more packages with things your stylist selected for you.

Doesn't this sound different from our traditional retail mall experience? A bit of research quickly brought this all into focus. Retail REITs must be watching the advent of rented apparel with some trepidation, due to the potential for disruption from extension of rentals to key mall tenants.

You may be surprised to hear how fast this change is already happening. Here is a short list of the brand-conscious mall retailers that have already started their own apparel rental options that complete with services like Le Tote, Gwynnie Bee Style Rentals, Rent the Runway, and StitchFix (NASDAQ:SFIX):

  • Ann Taylor offers Infinite Style for $69 per month
  • American Eagle (NYSE:AEO) offers Style Drop for $49.95 per month
  • Banana Republic offers Style Passport for $85 per month
  • Urban Outfitters (NASDAQ:URBN) offers Nuuly at $80 per month for 6 items up to $800 value
  • Express offers Style Trial for $69.95 per month for 3 items

Why are these specialty apparel retailers rushing to offer a rental service? They view it as providing a logical extension to support their frequent buyers who have little time to spend at the mall. The rationale says consumers should "buy the core items" and "invest in the basics" but "rent the fashion." Apparel rental subscriptions are viewed as an add-on service, offering a value-added experience to existing customers of the retail brand.

According a study from Grand View Research, published in April 2019, the online rental clothing market is already more than $1.0 billion as of the end of 2018 (read it here). According to Grand View Research, growth in apparel rentals is expected at a 9.4% annual rate from 2018 to 2015.

Price Performance of Retail REITs compared to Department Store Tenants

It is time for investors to true up their understanding of department store underperformance by reviewing some of the metrics I have assembled in the following tables. First, consider that department store tenants of Retail REITs have seen their stock prices decline (24%) to (49%) year to date for 2019, as shown below.

Stock Price Performance of Retail REITs and Department Store Tenants The worst-performing stock among department stores is now Macy's (M), down (49%) year to date for 2019. The best performer is Hudson's Bay, actually up 20%, due to the offer from its CEO to take it private, as discussed above. Even the stock of Sears Holdings (OTCPK:SHLDQ), bankrupt since October 2018, is down (24%) year to date for 2019, as additional layoffs and store closings indicate the restructuring plan is not going well. J.C. Penney's (JCP) stock tumbled down (35%) to below ($1.00) per share, as investors see debt restructuring efforts hampered by comp-store sales declines greater than expected.

In contrast, the stocks of Retail REITs have declined less, with Simon Property Group down (11%) and Taubman Centers down (12%) year to date for 2019. Despite dividend increases during 2019, Simon Property Group now yields 5.6%, while Taubman Centers now yields 6.7%. Macerich, a less popular stock among Retail REITs, is down (33%) year to date for 2019. Macerich also slightly increased its dividend during 2019, only to see the current yield at 10.4%, with the stock now at the lowest price for 10 years, since June 2009.

Sales Decline with Store Count Reduction

Disappointing metrics for the department stores are shown in the next chart, indicating serious sales erosion, due to both negative comp-store sales trends and the decision to close unprofitable locations.

Department Store Operating Trends Nordstrom (JWN) is the only one of the 5 department store chains shown to show sales growth for the period from FY 2016 (ended January 2016) to FY 2019 (the most recently reported full year, ended January 2019), due to the great success of Nordstrom Rack, reaching out from regional malls to add locations in strip malls and community shopping centers, offering lower-priced apparel in a high turnover format. Meanwhile, Macy's sales have decreased (8%), while the number of full line Macy's stores has decreased (20%). J.C. Penney's sales have declined (8%) over this period, while its store count decreased (17%). J.C. Penney's decision to exit furniture and appliance categories will cause a further dramatic sales decline this year. I estimate sales at bankrupt Sears Holdings have declined more than (50%), with number of full line Sears locations down (67%) and the number of Kmarts down (79%).

The last column of the chart above shows the latest comp-store sales reported for each department store. Only Macy's and Saks Fifth Ave reported growth for the July 2019 quarter, all others were negative. Looking at this, it is easy to see why Hudson's Bay is moving quickly to divest Lord & Taylor, with comp-store sales down (17%) for the most recent quarter.

Understanding Retail REIT Exposure to Remaining Department Stores

Even in the face of these appalling trends for department store tenants, I am still comfortable recommending Retail REITs. The reason is that while Retail REITs have real estate exposure to department store tenants, the rents from department stores are so low as to be almost insignificant, as shown in the table below.

Exposure to Department Store Tenants We can see this picture most clearly by considering the numbers provided by Simon Property Group in their Quarterly Supplemental Report for 2Q 2019. The real estate exposure is shown in the column labeled GLA (gross leasable area), showing Macy's occupying more than 12% of Simon Property Group's total portfolio space, while contributing only 0.4% of ABR (average base rents) for Simon Property Group. Adding all of the 5 department store tenants together, we see that these tenants account for 24% of Simon's total portfolio space, but still less than 1% of annual rents. (Note that Simon Property Group stopped accruing any rents at all from Sears Holdings after the October 2018 bankruptcy filing.) Taubman Centers only discloses to investors the GLA for its tenants, not the contribution to annual rents. Taubman Centers shows 35% of total space occupied by these 5 department store tenants, probably generating less than 2.0% of total rents.

Retail REITs tell investors that space vacated by bankrupt tenants can be redeveloped to earn much higher rents. Empty Sears stores may stay vacant for a year or more, but will eventually be opened up into new shopping and entertainment venues to restore life to a regional mall. Such turnover will earn the Retail REITs able to make these investments a substantially higher return than the department stores they replace.

Valuation of Retail REITs the Most Attractive in Years

In more than 20 years as a REIT investor, I have never seen yields so high for the highest quality Retail REITs, those with thriving regional malls. Retail REITs used to have the lowest yields of all REIT sectors, previously in the range of 2.5-4.0%. Now we see Simon Property Group yielding 5.4% and Taubman Centers yielding 6.7%, as shown in the table below.

Valuation of Retail REITs

As for my preferred valuation metric, the ratio of total capitalization (including not only market cap and debt, but also preferred stock and non-trading equity of minority investors) to current annualized FFO, I see these high-quality Retail REITs at 17x-18x total cap to FFO. For years, I have been used to seeing that metric above 25x, occasionally above 30x for high-quality Retail REITs.

Conclusion

Apparel rental is an interesting trend to watch. While not a replacement for traditional mall apparel retailing, it is refreshing to see that Lord & Taylor in the hands of Le Tote will soon be experimenting with ways to combine mall locations, offering opportunity for hands-on review of available fashions and the reassurance of a try-on, to be combined with services of stylist and a subscription rental service.

I conclude that all of the bad news on department store tenants is providing opportunistic REIT investors an exceptional opportunity to Buy the stocks of the highest quality institutional Retail REITs, Simon Property Group and Taubman Centers, at approximately half their previous valuations. The worse it gets for the department store tenants, the cheaper these high-quality Retail REIT stocks become. As for Macerich, the discount is even greater, making the stock a clear Buy. Although a 10% yield often invites a dividend cut, I consider that unlikely for Macerich, due to insider ownership and control of the stock.

As for department store retailers, Macy's is a Buy for a rebound back above $20 per share, given its important US market share and determination to revamp its offerings to make them more cost-effective. Nordstrom may also be a Buy, given the yield above 5.0%, although investors may wish to wait for the assurance of rebounding comp-store sales. Investors in Hudson's Bay Company should Hold for the expected management buyout. As for J.C. Penney and Sears Holdings, Sell is the only logical option.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.