Saks isn’t a stellar asset for HBC – but there’s potential

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You've got to give it to Richard Baker. He's marketed his acquisition of Saks Inc. like a champion.

His message to Canadians: this country has lots of room for another luxury retailer, and HBC's got the real estate for it.

Fair point. But let's keep this in perspective. His plan is to open, at most, seven Saks stores here. Yes, there are online opportunities and outlet potential above and beyond that, but the U.S. operation, with its 42 Saks 5th Avenue stores and 66 outlets, will always be much bigger.

And guess what, the U.S. earnings haven't been so hot. In 2012 the company's full year profit dropped to $63-million from $73-million the year prior, and in the first quarter of the current fiscal year Saks had to revise its gross margin guidance down to flat year-over-year because U.S. high-end retailers are caught up in a promotional war.

Saks is also transforming itself. Its online sales growth is now higher than that of its brick-and-mortar stores, so the chain's invested heavily in its online platforms. Saks.com just relaunched its website, and later this year the company will unveil Off5th.com.

There's also a big investment in a back-end platform dubbed Project Evolution, that ties together merchandising, finance and human resources divisions. Saks swears this will help them in the future, but management hasn't released figures that portend just how much they expect it to boost earnings.

Need even more proof? Since the start of 2010, the chain's shut 11 stores, and recently announced the closing of two more in Dallas and Stanford. And until May, when the news leaked that Saks had hired investment bankers to pursue different strategic options, its stock had been stuck in a 2.5 year lull.

So what exactly does Mr. Baker see? Maybe not success right out of the gate, but the possibility of some magic down the line.

As the Wall Street Journal reported , under a merged company, HBC could close some of Saks' underperforming stores and swap in Lord + Taylor locations, which cater to a different, lower-end demographic. "Basically where Lord & Taylor ends is where Sax begins," Mr. Baker said on a conference call Monday. "They have very, very little overlap."

Something similar could happen here. HBC already owns a boatload of real estate, allowing the retailer to close some HBC locations swap them for Saks stores.

Then there's the real estate investment trust. Mr. Baker, a real estate man, has long hoped to spin out some of HBC's properties into a REIT. Saks makes that even more possible. The chain operates in 32 million square feet of retail space, 17 million square feet of which is owned by the company.

It looks like Mr. Baker believes that beefing up his REIT with more properties could make investors like it more – in part because it lets them play a recovering U.S. economy – and that could boost HBC's valuation – much the same way Loblaw's stock bounced after announcing plans to spin out its own real estate into Choice Properties REIT.

But remember just how much leverage HBC is adding to finance this deal. Once combined, the company will have $3.2-billion in debt outstanding, a big figure considering that before the combination, Saks' debt was already more than 3 times its earnings before taxes, depreciation, amortization and rent. Together, the two companies don't expect this ratio to fall before 2.5 times for four to five years.

Because the debt is such a heavy burden, HBC will slash its dividend nearly in half once the deal closes "to accelerate deleveraging in the short term."