Hudson's Bay In Play

As details of South Carolina-based buyout artist Jerry Zucker's not-so-surprising $1.1-billion bid for venerable Canadian department store retailer Hudson's Bay Co. came to light in the last days of October, it was hard not to think of the old adage: Be careful what you wish for–you just might get it.

Certainly Zucker, if successful in his bid to buy out HBC (TSX: HBC) shareholders, will have the challenge of his career if he tries to resuscitate a tired retail business that's getting pounded from all sides. Discounters like Wal-Mart, speciality retailers and big-box stores are just a few of Toronto-based HBC's stiff competitors. Though he has proven himself a capable businessman–he's No. 346 on Forbes's list of the richest Americans, with an estimated net worth of US$1 billion–Zucker, who already owns slightly less than one-fifth of HBC stock, has no experience owning a retailer. Besides, if HBC, which operates the Bay department stores and Zellers discount outlets, was such a quick fix, why has no one else–say, a strategic buyer with a background in retail–stepped up to the plate? As Robert Gibson, analyst at Octagon Capital in Toronto, says, “If there had been any serious players, they would have come forward earlier.”

But the real question is whether Zucker, once he bags his prize, is truly in for the long run when it comes to overhauling HBC. Or is his unsolicited bid simply a way to flush other potential buyers out, then make a dash for the exit, taking away a nice profit in the process? Alternatively, does Zucker want HBC–a Canadian icon with a 335-year history–just so he can break it up, selling off assets such as the real estate portfolio and credit card division?

To hear Zucker's right-hand man, Robert Johnston, tell it, Zucker (who does not grant interviews) is committed to keeping HBC intact. Despite its problems, “it's still a wonderful company,” Johnston, VP of strategy at Zucker's private holding company, the InterTech Group Inc. Corp., says of HBC. He points to the company's great locations and “wonderful brand names.” Heck, Johnston says Zucker even likes the current management's five-year plan for fixing the company, which includes cutting costs, standardizing Zellers outlets, improving selection, and adding more big-ticket items and exclusive brands. While professing support, though, Johnston adds he and Zucker have concerns about how the plan is being executed, and about the dismal results that have followed. Since 2002, revenues have dropped to $7 billion from $7.4 billion, while earnings have dropped to 86¢ a share from $1.40. “Quarter after quarter, the results haven't been there,” Johnston says. “With its footprint, brands and name recognition, you'd think this company should be much more profitable.” If Zucker were to take over, odds are he would push aggressively to make things better, sooner. Says Johnston: “If you look at some very successful retailers, like Tesco [in the U.K.] and Target [in the U.S.], they are very good at taking on Wal-Mart. I think it would be great if HBC had a winning spirit.” Peter Holden of Veritas Investment Research Corp. believes Zucker is “quite serious” about trying to revive HBC. “They are doing this expecting to win.” Zucker may have no experience in retail, but Holden says “HBC's current management team knows a great deal about retail, and they consistently lose money. So maybe it is time for new ideas.”

But analysts aren't so sure Zucker wants to oversee all the work that needs to be done. “We are suspicious that Zucker may really only be trying to squeeze out another bid,” says National Bank analyst Jim Durran in a note published after Zucker announced his bid, which includes paying shareholders $14.75 a share and $1,010 for each $1,000 in principal for debentures due Dec. 1, 2008. (To pay off shareholders and debenture holders, Zucker has already arranged bank financing of more than $1 billion through Wells Fargo and ABN Amro banks.) Durran points out Zucker owns 18.8% of the stock, but his tender requires 90% approval from all shareholders, rather than the traditional requirement of two-thirds approval–“giving him an out if he needs one.” Keith Howlett of Desjardins Securities in Toronto thinks Zucker may be trying to “smoke out” potential buyers.

While no one is really surprised Zucker has finally made his move for HBC, given his large stake and reputation as corporate raider, the timing might have been influenced by HBC's announcement in early October to look at selling off its credit card operations. This would follow the lead of Sears Canada Inc., 54% owned by Illinois-based Sears Holdings Corp., which in August sold off the division for $2.2 billion. While Sears Canada's stock jumped 24% on its news, HBC's shares barely moved on its own announcement. Johnston wonders if that is the best way to create value for the company and says Zucker was concerned HBC is contemplating the sale of the only division that makes money. By stepping in, Zucker made it clear that as the largest single shareholder, he wants a say in what happens to the company's assets.

Whatever his long-term intentions might be, there's no question Zucker has been interested in making a play for Hudson's Bay ever since he started buying the company's shares almost two years ago, when they were trading at $9. While the official line has always been that his interest in HBC was simply a good investment on an undervalued stock, in a letter to HBC board governor Yves Fortier, Zucker slips in a telling detail: “As you know from our prior communications, including our letter dated Aug. 17, 2004, we are highly interested in acquiring HBC.” He also points out the HBC board rejected the earlier offer: “Although we had hoped that we could pursue meaningful discussions that would lead to increased value for your shareholders, we have been left with no choice but to take our offer directly to HBC shareholders.” In addition, Zucker asks for non-public data, in order to do due diligence, and for the board to waive its shareholders' rights plan. Says Johnston on the timing of the bid: “As the numbers started to come in weaker and weaker, we didn't think it was appropriate to sit here as the largest shareholder and watch the stock and the company's performance deteriorate.”

So far, HBC management, including CEO George Heller (who was en route from Europe to Canada when Zucker's bid was made public) has declined to comment on the offer. After Zucker's bid was received, HBC put out an announcement saying it had not yet received a formal offer, but when one is tabled, it “will make a recommendation to shareholders and the marketplace.” (At press time, Zucker's formal offer had not yet been sent to shareholders.) In an internal memo to staff following the news of Zucker's bid, Heller suggested a change of ownership isn't necessarily a negative development and that it “doesn't automatically mean a change in strategic direction.” As well, a few days after Zucker's bid was made public, HBC announced it was cutting 825 management jobs–part of a plan to save between $40 and $45 million in costs annually.

As for what HBC is worth, Durran says a sum-of-the-parts valuation of HBC works out to somewhere between $15 and $17 a share. The valuation assumes the credit card operations could be sold off at the same premium Sears Canada received, generating about $8 a share, while an annual $50-million payment stream for 10 years from the credit card sale would be added to operating earnings, working out to between $7 and $9 a share. Durran points out that if HBC's real estate assets were monetized, the valuation on HBC could be between $18 and $20. However, he says if the stock goes over $17, shareholders should consider the potential dilutive impact of convertible debentures being exchanged for equity. At the stock's current level–of around $15.50–Durran says there's little chance of such an exchange. But over $17, it becomes a possibility, with the potential to reduce the per-share valuation of HBC to $13 to $15 through the issuance of 11.5 million shares.

There's also the question of whether a rival bid will emerge. David Brodie, analyst with Research Capital, questions whether anyone will step up. He says “it is not unreasonable to assume that no higher offer will be forthcoming, and that only a slight face-saving sweetener may be required for Zucker's pending offer to obtain board and shareholder approval.” If there are other bidders for HBC, other analysts, such as Durran, suggest it would make sense for the offer to come from a financial player; that ultimately could lead to the merger of HBC and Sears Canada. However, Durran says it's unlikely Sears Holdings is interested in buying HBC. Durran singles out JPMorgan Chase, the purchaser of Sears Canada's credit card business, as a logical bidder. The bank could merge the two companies, reaping synergies on both the retail and the credit card operations.

Whatever the outcome of Zucker's play, retail watchers are cheering. “Not a minute too soon,” Merrill Lynch analyst Patricia Baker writes in her report on the offer. Baker adds that she has not detected a serious strategic plan from current management “that would result in better surfacing of value.” In fact, “an argument can be made that there has been considerable value destruction” for investors, she says, pointing out that in the past few years operating performance”has severely deteriorated.”

At the very least, putting Canada's oldest corporation into private American hands makes HBC's woes somebody else's problem. And who knows? If he decides to hang in for the overhaul, Jerry Zucker might find a way to make HBC work.