Earlier this year, Hudson's Bay (OTC:HBAYF) announced that it was considering strategic alternatives for its long-suffering Lord & Taylor brand. Even the best-run U.S. department stores have struggled in the face of the ongoing retail apocalypse, and Lord & Taylor hasn't been one of the best-run chains in the sector. It's clear that it would be extremely challenging to revitalize the brand, and Hudson's Bay wants to focus on operating its two best businesses: Saks Fifth Avenue and its namesake chain.

On Wednesday, Hudson's Bay announced that it had agreed to sell Lord & Taylor to Le Tote, a start-up that operates a fashion-rental subscription service. However, while Le Tote is paying for the struggling department store brand, Hudson's Bay has agreed to cover the rent for most of its stores for the next three years. In effect, this means that Hudson's Bay is paying a steep price just to get rid of Lord & Taylor.

Downsizing hasn't worked for Lord & Taylor

Over the past few years, Hudson's Bay has closed several Lord & Taylor stores in a bid to improve its profitability and cash in on some of its real estate value. Most notably, Lord & Taylor closed its Manhattan flagship store in early January after selling a majority stake in the building to an affiliate of WeWork at a princely valuation of $850 million.

A few months ago, Lord & Taylor announced that it would close four more stores: two full-line locations and two outlet stores. This would leave it with 43 locations, mostly in the Northeast.

However, these store closures are like putting a Band-Aid on a gaping wound -- and management knows it. Even bolder initiatives like opening a new e-commerce store in partnership with Walmart haven't helped stem the deterioration in Lord & Taylor's revenue and profitability. Last year, Lord & Taylor posted earnings before interest, taxes, depreciation, and amortization (EBITDA) of negative 119 million Canadian dollars ($89 million), including corporate expenses allocated to the division.

The parking lot and exterior of a Lord & Taylor store

Hudson's Bay hasn't been able to stem Lord & Taylor's losses by closing underperforming stores. Image source: Author.

Le Tote will take a low-risk gamble on the brand

Under the purchase agreement announced this week, Le Tote will pay $100 million for Lord & Taylor's brand and inventory (subject to working capital adjustments). It will also take over the leasehold interests for 38 of the 43 Lord & Taylor stores that will remain by this fall. The other five stores -- which have not been publicly identified yet -- will be liquidated and closed.

Le Tote will pay $75 million in cash at closing, with the other $25 million coming in the form of a promissory note payable in two years. Hudson's Bay will also receive preferred stock giving it a 25% stake in Le Tote and will control two seats on the start-up's board.

The main goal of the acquisition is to grow Le Tote's clothing-rental service. First, buying Lord & Taylor will garner additional brand exposure for Le Tote. Second, the deal will give Le Tote dramatically more inventory to rent out (if demand warrants).

Le Tote also thinks it can use its technological prowess to improve Lord & Taylor's core department store business over time. Still, taking over a struggling department store chain is a risky venture -- especially for a fairly small fashion-rental business. However, Hudson's Bay is dramatically reducing the risk for Le Tote by agreeing to make all the rental payments on the stores that the latter is buying for at least three years. Most of those stores are owned or ground-leased by a joint venture that is 62.4% owned by Hudson's Bay.

The rent that Hudson's Bay has agreed to pay totals CA$77 million ($58 million) annually, net of the profit it receives from the real estate joint venture. Thus, within less than two years of closing the deal, Hudson's Bay will have spent the entire $100 million cash proceeds on rent for a chain it will no longer own.

At least Hudson's Bay will save face

Hudson's Bay still hopes to make a profit from the divestiture of the Lord & Taylor chain -- but its strategy depends on monetizing the real estate for the roughly 30 Lord & Taylor stores owned or ground-leased by the HBS joint venture. Under its agreement with Le Tote, Hudson's Bay has the right to recapture up to 28 of the stores the former is buying over the next several years. The joint venture could then sell or redevelop those properties for other uses.

This raises the question of why Hudson's Bay isn't just moving straight to monetizing the real estate. Part of the reason is that it can take years to plan the redevelopment of a department store. If it had kept Lord & Taylor, Hudson's Bay would have been on the hook for the rent at least until the redevelopment began, so from that perspective, it isn't losing anything by paying the rent for Le Tote. Meanwhile, it won't have to cover the rest of Lord & Taylor's operational losses after completing the sale.

Another advantage of selling the brand is that Hudson's Bay won't be directly responsible for thousands of job losses. Given the depth of Lord & Taylor's losses and the pressure facing the department store sector, it's hard to imagine that Le Tote will ever be able to pay market-rate rent for Lord & Taylor's stores. As a result, it is likely to close (or possibly downsize) the vast majority of the stores it is taking over within the next five years.

However, Le Tote may be able to offer Lord & Taylor employees other roles in the company by then. And if not, at least Hudson's Bay won't have to shoulder all of the blame for the eventual job cuts. The financial terms of the Lord & Taylor sale are not very advantageous for Hudson's Bay, but the deal with Le Tote still might be better than anything the department store conglomerate could have done with the brand on its own.