asset heavy to asset light

A generation or two ago, the style in the US was for companies to own the premises their businesses operated in–hotels, department stores, restaurants and the like.  One major disadvantage of this approach, however, is that it takes a huge amount of capital to be able to expand.

About the time I was entering the stock market, American hoteliers had worked out that they could sell their properties to the local doctor, dentist, accountant, or oil sheikh and take back a management contract.  They found the buyers were more interested in the prestige of ownership than in profits.  They were willing to pay very high prices for the properties, while ceding virtually all the hotel cash flow back to the management company.  The “asset light” movement was born.  (Around a decade later, European hotel firms caught on and began to do the same thing.)

Hotels are admittedly an extreme example.  In my experience it rarely has made economic sense to own a hotel.  Better  an office building if you want to own real estate.  Still, asset light is the current style in many industries.

hybrids are potentially interesting

Many hybrids–a mix of leased and owned properties–remain, however.  They can sometimes present interesting investment opportunities.

An example:

At one time a friend pointed out the W Company (not the real name) in Hong Kong.  It was (and still is) a publicly traded, family run department store in Hong Kong, located in the heart of the high-end Central district.  The financials showed that the company was consistently, and highly, profitable.

But when I went to visit the department store itself, it looked more like K-Mart than Neiman Marcus.  The merchandise was undistinguished, the premises dowdy, customers few and far between (observing this last on a company visit is seldom a reliable indicator, though).  The store was surrounded by more modern, glitzy alternatives.  And Hong Kong is all about glitz.

How could this straw-into-gold story be true?  Looking a little closer, I noticed that the department store showed no rental expense on its income statement.  That’s because the company itself owned the building it operated out of.

I checked rents on nearby retail premises.  It turned out that W would probably be paying HK$100 million to a third party to rent the space it was in.  But the department store was only making HK$30 million in annual operating profit. (I don’t remember the exact numbers so I made these ones up.  But they’re roughly correct.)

The economic reality …

…was that W had two separate businesses:

–property ownership, which should have been generating HK$100 million in income, and

–department store retailing, which should have been adding to that.

The company was actually losing HK$70 million from retailing and subsidizing the department store by forgoing the rent it could have earned.

That was, in theory at least, the investment opportunity.  Either the family elders would wake up one day and realize they could triple their profits by closing down the department store and renting out the premises, or a predator would come along and bid for the firm.  The big question in the second case was whether the family would sell.

not alone

In the case of W when I was looking at it, my impression was that the family had never analyzed its business and was perfectly happy with the status quo.  When potential bidders came calling, the elders just said no.

My first instinct is to say that this behavior is crazy.  On the other hand, except for the location and the family owners blocking a change of control, this is the J C Penney story in a nutshell.