By: Jeff Pollock
November 13, 2017

It didn’t take long for the department stores in downtown Toronto to unofficially kick off the holiday season with their decorative displays. If estimates published by the National Retail Federation are correct, annual sales will grow by 3.6 to 4.0% this upcoming holiday season (if you’re wondering, the 5-year average has been 3.5%).

Over the last year, department store stocks turned out to be a disappointing value trap for its investors. The share prices looked cheap a year ago, but traded inexpensively for good reason. Same-store sales were for the most part weak yet again this quarter. Sales at Macy’s, for example, dropped 4% year-over-year, its eleventh consecutive quarterly decline.

The contrarian argument to own shares in a department store has not been that online sales will disappear (or slow down) any time soon. In fact, only 12% of retail sales are presently made online. Desktop and mobile sales are growing at 17% and 59%, respectively. Instead, contrarian investors have brought attention to the disconnect between department store share prices and the value of its real estate to construct a compelling risk-reward argument.

Several Canadian companies have successfully monetized its real estate in the past to realize shareholder value. Loblaw did so in 2012 when it created Choice Properties REIT, and Canadian Tire followed the next year when CT REIT was created. Both act as the anchor tenant for each respective REIT (Real Estate Investment Trust) that was created.

However, a newly created REIT with a department store anchor tenant is likely to be met with tepid investor demand. Instead, repurposing much of this space may be the most probable outcome if any real estate value is to be monetized.

Brookfield Asset Management CEO Bruce Flatt wrote in a letter to shareholders this most recent May 2017 that:

As department store companies rethink their business models, they have been sellers of assets at prices we find attractive. We can integrate these boxes into our malls and redevelop these assets to bring in new tenants[.] … Regional shopping centers are horizontal assets with large parking footprints which can allow for great creativity in the redevelopment process. We are finding significant opportunities with continued urbanization to add multifamily residential rentals, condominiums, hotels and office uses to these large pieces of real estate.

Should department stores look to monetize their real estate, department stores with assets situated in urban centres (as opposed to rural communities) will likely attract the strongest interest from investors. Under pressure from an activist shareholder, Hudson’s Bay recently sold a Fifth Avenue building for $850M and also announced that it’s looking to sell their Vancouver flagship for up to $900M. RioCan is also slimming down as it looks to sell 100 properties, mostly in smaller Canadian cities, to focus on Canada’s larger markets (Toronto, Ottawa, Vancouver, Calgary, Edmonton, and Montreal).

Despite the real estate value, Vestcap’s Investment Committee is not presently bullish on the sector. As contrarians, we generally draw our attention to sectors out of favour. Furthermore, we believe that activist investors will continue their fight to monetize department store real estate. However, today’s market is applying a valuation premium to companies that have a “disruptive” business model and a discount to those that don’t. Our belief is that the discount being applied to department stores could stretch further to the downside if holiday sales disappoint or activist shareholders are unsuccessful in their battle to monetize assets. Consequently, we’re watching this particular sub-sector on the sidelines for the time being.


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