This Recent IPO Shows Us That Brick-and-Mortar Retail Still Has Legs

Airport retailer Hudson Ltd (HUD) priced its initial public offering in February. While the stock has declined in its brief time on the public markets, the company itself has more than a few trends working in its favor.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma walk listeners through Hudson's business model, financials, risks, and outlook. Thanks to the unique perks (and challenges) of operating in airports, Hudson is delivering impressive results for a brick-and-mortar retailer.

A full transcript follows the video.

This video was recorded on March 20, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, March 20th, and I'm your host, Vincent Shen.

Now that we're almost finished with the first quarter of 2018, I wanted to check in on IPO activity in the consumer and retail sector. There have been a couple debuts. For this episode, our focus will be Hudson Ltd, a $1.5 billion company. Though Hudson is not a household name right now, if you've done any traveling recently, you've probably seen or even done business with Hudson.

Joining me via Skype for this IPO discussion is senior Motley Fool contributor, Asit Sharma. Welcome back, sir!

Asit Sharma: Thank you very much! What up, Fools?

Shen: I appreciate you coming on the show today. I'm going to dive right into our discussion.

We have Hudson Limited, ticker HUD. I mentioned that frequent travelers are likely familiar with this company, because Hudson operates 1,000 newsstands, bookstores, duty-free shops, and other retail storefronts in North America with 95% of its revenue generated at airports.

Hudson priced its IPO at $19 per share at the beginning of February. The deal raised $750 million, and at its debut, the company had a valuation of close to $1.8 billion. But shares have declined in their first month and a half of trading. Before we came into the studio, the stock was right around $15 per share, giving Hudson that $1.5 billion market cap.

There's a lot of variety in its retail footprint, which is really interesting, because Hudson stores can range from minimalist 200 sq. ft. to 10,000 sq. ft. They come under the company's own banners like Hudson and Dufry, but they also partner with third-party brands like Coach, Tumi, and Dunkin' Donuts.

Airport concessions are the name of the game for this company. I'll pause there and swing to you, Asit. What jumped out to you for this business?

Sharma: A bit a background on the business that shareholders or prospective shareholders should know really jumped out at me, and that is that this IPO was conducted by Hudson's parent company, which is Dufry AG. This is a European company. It's one of the largest global airport concession retailers in the world. They have about 2,200 stores in 64 countries. They took all the proceeds from the IPO to pay down their debt. Hudson didn't receive any of the proceeds for its own purposes. 

The other thing to be aware of this, this is still going to be a company which is controlled by Dufry. They have stacked the board with their own members, they have the control of the voting interest. Just a quick explanation, the IPO created two classes of stock: A shares and the B shares. The A shares are what shareholders will buy, the common stock. B shares are all retained by Dufry. B shares have voting rights of 10:1 over A shares, so basically, Dufry has all the control. 

Having said that, this is a very interesting company. I'll give a few statistics on revenue and earnings. We can delve into this a little further. Last year, in 2017, Hudson retail generated $1.8 billion of revenue. That's about a 7% improvement over the prior year. It had a really healthy gross margin of 62%, which helped it generate before-tax profit of $32 million, which is about double the prior year. So this is a profitable company. It's growing at a reasonable clip. 

Net profit was actually a loss of roughly $11 million, and that was due to a one-time tax adjustment. Those of you who are following the effect of the recent U.S. tax legislation on the companies you own have often seen benefits for companies which are U.S.-based and do business globally. But since Dufry is sort of the opposite -- it's partially owned by an overseas entity and does business primarily in the United States -- it got the reverse end of the stick in that it has some net operating loss carryforwards that it could have used in the future to offset some future income tax liability. It had to take a hit this year, but it got that out of the way. This is a healthy company. 

One more thing to note globally about it, and then I will flip it back to Vince. Let's talk about the revenue composition, because this is important. About 76% of the company's revenues are duty paid, and about 24% are duty-free. The duty-free revenue comes from brands that it licenses from the parent company, Dufry. If you've been traveling in the past few years anywhere in the world, you've probably seen brands like Dufry, Nuance, World Duty Free, those shops that you walk in to maybe to buy some duty-free liquor, it licenses those brands. The rest of its revenue is duty-free. 

Eighty-one percent of sales come from the United States and about 19% from Canada. Let's slice the revenue one more way -- 94% of its revenue, as Vince said, is derived from airports. The balance is hotels, train stations, and in New York City, those kiosks that residents are very familiar with, the Hudson News brand, which is something I was very familiar with when I was in grad school in New York in the mid-1990s.

Of what it sells, food and beverage is the largest category at 35%, and that's followed by perfume and cosmetics at 14%. Literature, meaning news and books, at 12%. Fashion, so, clothing items, at 11%. And other revenue is 11%. Then, it breaks down into some smaller categories. So this is a global view of what the company sells, how it sells, and where it sells.

Shen: Thanks, Asit. I'll touch on a few additional details, especially on some of those product categories that you mentioned. I mentioned before that Hudson has a lot of different retail concepts and store formats. Think convenience stores, duty-free, electronics, book stores, and food and beverage as well. The company has over 200 concession agreements, but its key locations aren't that much of a surprise, given its concentration in airports. If you think about Chicago O'Hare, where it has 49 stores; JFK International, another 40 stores; Vancouver International, 43 stores; Los Angeles International, 48 stores; and then McCarran in Las Vegas, another 33 stores. Just those five airports account for over 20% of the company's total store base. 

Among that store base, Asit, you broke down some of those product categories, like food and beverage, perfumes and cosmetics, and fashion making up a lot of that top line. But something that's interesting, I think, about this is, you have kind of a traditional brick-and-mortar retail operation, but the company mentions in some of their filings unique influences on its customers. Due to the concentration of Hudson's concessions in airports, the company gets a relatively stable and predictable flow of customer traffic. Unlike traditional brick-and-mortar, like the shopping malls and shopping centers of the world, air travel is actually growing more popular, which means more passengers and potential customers wandering around airport terminals. 

Along with that, a lot of travelers will build potential shopping time, or what the company calls "dwell" time, into their travel plans. Fools who have flown before are familiar with the idea of arriving at the airport two hours or more before their scheduled flight time in case the check-in or security lines are particularly packed. But at larger airports, dwell times are estimated to be well over an hour. So if you get through with all that time to spare, for Hudson, that's basically a window before you board your flight where it's an opportunity for them to tempt you into making some sort of purchase, often times an impulse purchase.

Then, you add to that the fact that flyers tend to come from higher income demographics, that travelers are often rushing, a lot of airlines are reducing their in-flight services like meals to offer cheaper airfare, and there's more spending taking place at airports themselves. Overall, I think it's important to note that the market for airport concessions in North America comes out to over $9 billion annually, so a rather significant market for Hudson to tap into.

Alright, Asit, let's hit a few more quantitative parts of this company, and then we can look at some of the results, in terms of what Hudson actually reported recently for the full-year 2017. You mentioned revenue growth of about 7% to $1.8 billion. I thought it was also impressive that their same-store sales were up 4.7% in 2017. Not a lot of brick-and-mortar players can boast those kinds of numbers. Their gross and operating margins expanded as well. It helps that Hudson, especially in the North American market, the big player in this industry, could benefit from some of that scale. They have a lot of these strong relationships with airports, for example, and some of these other venues, where they can lock down these multi-year concession agreements and work with their suppliers, improve pricing, innovate with some of their store formats and the different things that they're offering to travelers in these locations.

Looking ahead, I think what was really impressive was what management guided to in terms of the numbers that investors can expect. For example, they guided toward high single-digit organic net sales growth, low double-digit adjusted EBITDA growth, and high-teens growth for net income, that's the bottom line. Those are pretty robust figures for a brick-and-mortar retail operation. Again, I think that speaks to the unique nature of operating in these high-traffic regulated environments like airports, where Hudson has these concession agreements. 

Then, on the valuation side, I wanted to mention, the stock trades close to $15 per share, or was right before we came into the studio. That gives it a forward price-to-earnings multiple of close to 20x. Nothing outlandish, I think, given the high-teens earning growth that management has mentioned. Any thoughts there from you, Asit? For the valuation?

Sharma: Sure. That valuation is right in line with consumer discretionary figures if you look at the aggregate. I always use the S&P 500 Consumer Discretionary Sector, which longtime listeners have heard us talk a lot about on the show, I use them as a benchmark. That forward evaluation for that group tends to run at 20x to 21x forward earnings, so right in line. 

What's interesting to me is that the numbers that you mentioned, Vince -- and I was impressed by this, too. We talk about so many retailers, and they're always going the other direction with negative growth. But this high single-digit organic revenue growth, high-teens net income, the low double-digit EBITDA, those numbers are predicated on two different statistics that, in the prospectus, Hudson covered. One is that North American passenger volume is growing at a compounded annual growth rate of about 3% a year and will continue that progress through 2025. The company also says that the average passenger spend has increased at a 4% rate each year. When you take those two numbers together, increasing people coming into airport terminals and increasing spend, it's a pretty good business proposition.

Those of you Fools listening today who are subscribers to some of our Premium services have come across companies like Grupo Aeroportuario del Pacífico, which is a company that I cover for Premium services each earnings quarter. You're probably familiar with this idea of traffic flow into airports. When you have a growing economy -- and this company I just mentioned is an airport operator in Mexico, where the travel business is booming both for tourism, domestic travel, and business reasons. Here in North America, we're not doing so badly, either. We're growing at that 3% to 4% clip. When you have that, and you have these fixed locations within the airports, you stand to benefit. 

Really briefly, I want to mention some of the risks involved in that model. This has to go with the way the leases are spelled out. Usually, you're exposed to something called a minimal annual guaranteed payment to your landlord when you win an airport concession. That means, let's say a terminal decides to move some of its flow to another terminal. You're stuck there. You have to make a minimal payment to your landlord every year that's based on an agreed-upon formula. A big travel event like 9/11, which unfortunately can really hit the industry hard, is also a risk that you face when most of your business is in the airport terminals. On the other hand, Hudson is a well-known name, so in competitive bid situations where they look to expand, they have an edge over their competition in that airports recognize that this brand brings in travelers. 

I want to put one more qualitative piece to why that traffic grows so much. Vince, you mentioned people planning in time, this is called dwell time, maybe, to shop on their way between destinations. Sometimes, and this has happened to me on many an occasion, you're stuck in an airport and sheer boredom makes you spend. After an hour or two, I get bored, I have to have something to read, or I need to buy some gum or maybe a T-shirt to take home. I think that's an important part of this business model. A less-celebrated aspect.

Shen: Sure. I think that's a good transition point for us, in terms of some of the risks that you mentioned. I think, the things that really have weight here in my view for this company and this stock are the last couple topics that we'll cover here. First, some of the issues with the relationship that Hudson has with its controlling shareholder, Dufry; and second, there's the longer-term road map for expansion for this company. 

Again, as you mentioned, Asit, you have to keep in mind that Dufy holds all of the class B stock, those 10 votes per share. I think it has over 90% of the voting interest in Hudson. It's always something for investors to keep in mind when another entity has that controlling interest, we like to call that out when evaluating a stock and because that affects some of the actual business relationship that Hudson has due to its obligations to deal with Dufry, in terms of certain supplier relationships and things along those lines.

But last but not least, I also wanted to look at the broader outlook for Hudson. For the company to grow, you mentioned some of the high-level tailwinds that it has in terms of passenger traffic, people spending at airports. I think there is also the more straightforward option here where Hudson is able to lock down more concession agreements, grow the number of stores it has, for example, in existing locations. 

But looking beyond that, the company is also starting to expand outside of airports more and more. It already has a presence in most of the major airports, so the company is ultimately going to have to seek out other places where it can operate stores. For example, you can find Hudson in a few tourist attractions like the Houston Space Center, the Empire State Building. But a more recent development, in June of last year, Hudson opened the stores at the Hard Rock Hotel and Casino in Las Vegas. I think non-traditional venues like that will be very important to Hudson's long-term growth.

Usually, we can point to international markets as another major opportunity, but I think, again, due to the company's relationship with Dufry and its own operations abroad, I think that's less likely to be something that Hudson can gain a lot of exposure to. But on the other hand, Dufry and Hudson are no stranger to acquisitions. Hudson itself was a 2008 buyout. Then, it was followed by Nuance in 2014 and World Duty Free Group in 2015. The North American operations for those two acquisitions were rolled into the Hudson enterprise. Keep in mind that there are other smaller and regional concession operators that can be rolled into Hudson's portfolio.

We have about a minute here, Asit. Any final thoughts or takeaways on your end?

Sharma: I think this is an interesting company to start following for all the reasons we've mentioned: the long-term growth potential, the fact that it has a build between organic growth and new store expansion to increase its value over the long term. I do like that the company is trying to maximize every last bit of square foot in its airport stores. It's experimenting with different store formats, as you mentioned, Vince. And they're trying to optimize that food and beverage category, which carries a high margin. 

The flip side, which we talked about, the control by Dufry, is something to keep in mind if you're going to buy the stock. But wait a few quarters this year, and let's see how the company operates as a public company and get more of a specific growth plan from management as the year winds on. This is not a stock I'd plunge into, but definitely put this on your watch screen. It's intriguing.

Shen: Yeah, I completely agree. I think when it comes to brick and mortar, a lot of the thriving retailers that we've talked about either have some sort of brand strength, large scale, or special niche that they can tap. If you think about dollar store chains, discount retailers, the luxury brands, I think Hudson definitely falls into this group as well, and the same-store sales and earnings growth speak to that strength. But in the end, we often advise Fools to give young public companies like this at least six months to a full year after their initial public offerings before taking a position. But Hudson, I think, is definitely going to be a name that we follow up on in 2018.

Thanks again, Asit, for hopping on, and thanks for listening, Fools. We'll have more IPO coverage for you coming soon.

People on the program may own companies discussed on the show, and the Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!