Description

Investment Thesis:

The recent, dramatic sell-off across retail equities has created a compelling long investment opportunity in the equity of Macy’s, which is in our view a classic case of the baby thrown out with the bathwater. Macy's is a best in class department store retailer with an exceptional omni-channel presence (7th largest online retailer), real estate value that significantly exceeds its entire enterprise value, and a management team with a proven record of returning cash to shareholders via dividends and share repurchases. The Company is actively engaged in discussions with Starboard Value about unlocking shareholder value with respect to its extensive real estate portfolio. A recent Starboard Value presentation can be accessed here:  

http://www.starboardvalue.com/publications/Starboard_Value_LP_Presentation_M_01.11.16.pdf.

Starboard estimates Macy's real estate assets are worth $20.7 B, $44/share (31% above current prices) after deducting for all of Macy's indebtedness, and before ascribing any value to Macy's iconic core retail business which generates substantial free cash flow. Macy's is 2.3x levered, sports a 4.5% dividend yield, and by our estimates will return more than 20% of its market cap to shareholders in 2016 via stock buybacks and dividends before receiving any credit for real estate monetization. The company has begun the process of unlocking the value of its vast real estate portfolio, including adding William Lenehan to its board of directors in March 2016. Lenehan is the president and CEO of Four Corners Property Trust (FCPT), the REIT created by Darden Restaurants in 2015 (with heavy prompting by Starboard) to successfully monetize their real estate assets.

While Macy’s retail business is undergoing transformation and faces threats from brick and mortar and e-commerce players (see risks section below), the company has been a leader in successfully executing on an omni-channel strategy which positions it favorably relative to its traditional competition. We estimate that Macy's generates 22% of its retail sales via its e-commerce platform, where growth is double-digits, while sales growth in its mobile platform is even greater. Additionally, Macy's remains a leader in the hard to replicate, and highly profitable, wedding registration business.  

Notwithstanding our general aversion to traditional bricks and mortar retail businesses, we view Macy’s as an exceptionally cheap sum of the parts story and believe that upcoming real estate monetization activity will propel the stock out of its recent doldrums. At 10x our F2016 and F2017 our cash earnings estimates, the stock would trade at $51 and $57, a gain of 52% and 69%, respectively, from the current stock price, prior to any consideration to real estate value or expected monetization. Assuming no sales growth from a better retail environment, and no benefit from Macy's new merchandising and e-commerce initiatives, we expect cash earnings to grow in F2017 and F2018, simply due to the company's rapidly shrinking share count. Further, we note sales in 4Q:F2015 and 1Q:F2016 were significantly impacted by usually warm weather (El Nino), heavily dampening winter apparel sales and leading to significant discounting by Macy's and its competition. With easy year-over-year comparisons and a possibility of unusually cold weather (La Nina), the risk to our sales (and EBITDA) forecasts is skewed to the upside.

We see the extensive real estate value as a floor to the stock and expect that any good news on either the core retail business or on the real estate monetization will propel the stock higher from currently depressed levels. Stock buybacks in the current year, which could total 15-20% of outstanding float (if done at current prices) represent another floor to the stock.

In summary, we believe that Macy's represents a compelling investment opportunity at current prices and believe the stock can appreciate 50-100% over the next 12-18 months as the Company executes on its real estate monetization, extensive share buybacks, and its retail turnaround strategy.

Description:

Macy’s, Inc. is a department store retailer with approximately 870 stores in 45 states, the District of Columbia, Guam, and Puerto Rico, with store banners including Macy’s, Bloomingdale’s, Bloomingdale’s Outlet, Macy’s Backstage, and Bluemercury, as well as various e-commerce sites.

Macy’s competes in the highly competitive mid-tier department store market, which is increasingly losing sales (and market share) to more nimble pure-play online players, with Amazon having become a competitive threat even in fashion apparel. Within the traditional department store segment, Macy’s mostly competes with J.C. Penney (JCP), Kohl’s (KSS), Dillard’s (DDS), and Nordstrom (JWN). In addition, as shoppers increasingly search for bargains, Macy’s now competes more aggressively with off-price department stores, such as TJX Companies (TJX) and Ross Stores (ROST). While first quarter same-store sales for Macy’s dropped 6%, TJX generated a 7% comp increase.    

Comparative Valuation

* Proprietary estimates for Macy’s and consensus for all others.

**F2016 ends in January 2017; F2017 ends in January 2018.

Why this opportunity exists

Weak retail environment has left retail stocks washed out

During the earnings season for 1Q:F2016, almost all retailers reported dismal results and lowered their full-year guidance. This sent the retail industry into a tailspin, with many retailers reaching new 52-week lows. Macy’s shares bottomed at $30, a 5-year low. F2016 is simply a transitional year for apparel retailing, with weather, economic, and fashion headwinds, which have inhibited store traffic. With weak expectations for F2016, F2017 will benefit from easy year over year comparisons.

Investors have lost confidence in retail, particularly mall-based retailers. Department stores were particularly hit hard. 1Q:F2016 same-store sales fell 0.4% at JCP, 3.9% at KSS, 1.7% at JWN, and 5% at DDS. And, Macy’s comps were down 6%. Making matters worse, AMZN reported an exceptionally strong quarter, with its North America sales up 27%, perpetuating fears that AMZN will eventually dominate apparel retailing. Among this backdrop, investor panic and fear over the long-term prospects for department stores reached a crescendo, given their locations (malls), demographics (older), and e-commerce (Amazon).

Real estate monetization provides Macy’s shares with a floor

In November 2015, Macy’s announced that the Company would explore joint venture and other opportunities to monetize its real estate portfolio. Within the consumer/retail industry, monetization of real estate assets has become a popular strategy for activist shareholders to promote to unlock value. We have seen these types of campaigns with varying levels of success at companies, such as Sears Holdings (SHLD), McDonalds (MCD), and Darden Restaurants. The Hudson’s Bay Company (HBAYF) has also recently begun to monetize some of its real estate assets.

Many times these campaigns occur when the subject company’s core operating business experiences challenges. There are many types of transactions to monetize real estate assets, such as sale/leasebacks and joint ventures. We think Macy’s is now serious about monetizing its real estate. In March 2016, William Lenehan joined the board of directors. Lenehan is the president and CEO of Four Corners Property Trust (FCPT), a REIT that manages restaurant properties formerly owned by Darden Restaurants. Starboard was the activist shareholder credited with pushing Darden to monetize its real estate assets.  In April 2016, Macy’s appointed Doug Sesler, as executive vice president for real estate. Earlier in his career at Bank of America Merrill Lynch, Sesler was the global head of principal real estate investments and global co-head of real estate investment banking.

Even before these personnel additions, Macy’s announced that Tishman Speyer would “advise and support the company’s senior management team identifying and advancing potential store redevelopment projects nationwide” such as joint ventures.

We do not think that Macy’s will pursue a sale-leaseback strategy to monetize its real estate. Management has previously rejected Starboard Value’s proposal to spin off real estate assets into a REIT, but nevertheless appears motivated to work with Starboard to monetize its vast real estate portfolio. Macy’s is conservatively managed and its leadership simply does not want to saddle the Company with more debt or incremental expenses (i.e. lease payments).  

Recently, Macy’s sold underutilized portions of store real estate in Brooklyn and Seattle. In addition, Macy’s has sold entire retail properties in Cupertino, CA and Pittsburgh, PA where the value of the real estate exceeded that of the retail business at those locations.

In the near future, we expect Macy’s will redevelop its large, flagship properties in Manhattan (Herald Square), San Francisco (Union Square), Chicago (State Street), and Minneapolis (Nicollet Mall).  We think Macy’s may partner with restaurants, entertainment venues, and/or offices to add alternative uses to these properties.

This is a potential structure for a joint venture that Macy’s may seek with a real estate developer: Macy’s would place certain real estate assets into the deal and have the developer contribute assets (properties and/or cash) to earn its equity stake in the deal. In return, Macy’s would receive cash proceeds from third-party debt issued by the joint venture entity.  The joint venture would be recorded with the equity method of accounting, resulting in a limited impact on cash flow, as joint venture indebtedness is not consolidated on the balance sheet.  

Macy’s strong record of returning value to shareholders with significant dividends and stock buybacks

Macy’s returns cash to shareholders with a 37.75 cents per share quarterly dividend ($1.51 annually), resulting in a current 4.5% dividend yield. In addition, at the end of 1Q:F2016, Macy’s had $1.9 billion remaining on its share repurchase authorization. We believe at currently depressed price levels, management is actively buying back shares. As the table below depicts, Macy’s has a demonstrated track record of significant share repurchases. Based on the current authorization and assuming a $35 average repurchase price, Macy’s would retire more than 20% of its shares outstanding in F2016. This share buyback would further provide material upside to Macy’s valuation and serve as another backstop for shares.

Our Perspective

We think Macy’s is a best-of-breed retailer, not only within the department store sector but within the retail industry overall. Despite the near-term challenges facing the industry, particularly apparel retailing, we view Terry Lundgren as one of the best CEOs and visionaries in the industry. His legacy now hinges on how successfully and quickly Macy’s evolves its omni-channel strategy.

While investors are fearful that the department store industry is old-fashioned and perhaps an anachronism in today’s Internet retailing age, we think these concerns are exaggerated. While clearly third-tier traditional malls are experiencing seismic problems, class A and class B malls will adapt to the changing consumer landscape. We believe rather than brick and mortar retailing becoming extinct because of e-commerce, the most successful retailers will synthesize brick and mortar retailing with e-commerce. Moreover, rather than the entire department store sector fading away, we expect further consolidation within the sector, with only the strongest players surviving. Under this scenario, we see Macy’s as among the best positioned to not only survive but gain market share.

Within retail, when shopping for apparel and shoes, touch, size, and fit are essential.  These are factors that dissuade some shoppers from buying online. Further pain points with online shopping are ease of returns, quality of customer service, and costs of shipping. Brick and mortar retailers are uniquely positioned relative to pure-play online retailers to excel in these areas. Further, at some point, pure-play online retailers will need to demonstrate the ability to generate profitability, as we continue to be in an environment where revenue and number of customers appear to be valued more than actual profitability. As a result, internet retailers pour millions of dollars into free shipping and digital marketing which together create high customer acquisition and retention costs that may never be recouped.

Macy’s already has among the best e-commerce platforms (7th largest by sales volume in the industry), an often overlooked fact amid the current noise. We conservatively estimate that Macy’s e-commerce sales were at least $5.9 billion (22% of sales) in F2015 and are growing rapidly.

We suggest that the current size of Macy’s e-commerce platform provides a strong foundation for management to adapt and further solidify its long-term omni-channel strategy. From a competitive landscape, Macy’s merchandises higher quality and higher-end national brands than do competitors, such as KSS and JCP, with brands such as Calvin Klein, Brooks Brothers, and Lacoste. Moreover, we think Macy’s proprietary brands (Club Room, Charter Club, etc) have stronger perceived quality than do those of KSS (Sonoma, Croft & Barrow, etc) and JCP (St. John’s Bay, Stafford, etc). Moreover, Macy’s is determined to excite customers with exclusive, unique merchandise, such as Love Bravery (apparel and accessories supported by Sir Elton John and Lady Gaga), WHT Space (men’s collection designed in collaboration with X-Games Gold Medalist Shaun White), and wearable technology from Samsung and other brands.

From an operational standpoint, Macy’s is focused on testing out new innovations and concepts within its stores. These growth initiatives include:

(1)    Macy’s Backstage – This is Macy’s off-price concept that is being tested on a standalone basis and in traditional stores. Despite the misperception on potential cannibalization, in-store locations are not in Macy’s best performing locations and therefore are strategic to generate store traffic. In addition, the merchandise at Macy’s Backstage either could not sell at full price or is manufactured specifically for the concept. As a result, we think Backstage could attract new customers to Macy’s from competitors, including KSS, JCP, TJX, and ROST. There are six stores-in-stores open, with nine additional ones to be open by 4Q:F2016.

(2)    Top Door Strategy – This is Macy’s intensified focus on its best performing 150 locations to further transform them into destination stores through stronger merchandise presentation in key departments, additional licensed departments (store-within-a-store), enhanced staffing for stronger customer service, and increased local marketing. This strategy is designed to retain current customers and attract them to visit the stores more frequently.

(3)    Mobile – Mobile is a key part of Macy’s overall omni-channel strategy. In 2015, mobile commerce doubled for Macy’s. The Company is investing significant CapEx into mobile commerce capabilities to further strengthen the platform and infrastructure.

(4)    Bluemercury – Macy’s acquired Bluemercury, a luxury beauty retailer with standalone locations. The Company plans to open Bluemercury boutiques within the best performing Macy’s locations, supporting the Top Door Strategy. There are currently five in-store shops with 17 additional ones to open by 4Q:F2016.

The Numbers

Balance Sheet

Macy’s has a clean balance sheet, with $6.9 billion in net debt and a relatively modest leverage of 2.3x F2016E EBITDA. Debt is comprised of senior notes and senior debentures.

* Maintenance CapEx primarily includes store remodels, whereas Growth CapEx for omni-channel initiatives.

We suggest that Macy’s strong free cash flow generation has been largely overlooked by investors concerned by the current weak retail environment. Since Macy’s has undertaken a significant cost-reduction program, we project that even with a 5% decline in top-line sales in F2016 and a 11% drop in EBITDA, Macy’s will generate $5.11 per share in FCF (15% yield). Further, with flat expectations for F2017, we estimate Macy’s will generate $5.69 per share in FCF (17% yield), buoyed by the significant share repurchase program in F2016.

Risks

A number of threats are currently plaguing traditional retailers including but not limited to: a) slow wage growth; b) consumer disposable income soaked up by rising medical and housing costs; c) competitive threats from e-commerce players (AMZN) and off-price retailers (TJX, ROST, etc); d) perception that millennials have forsaken the brick and mortar channel; e) shift in consumer tastes away from possessions and toward experiences; and f) perception that America is overstored and overmalled.

There are some mitigating factors to these risks:

Wage growth - Barring a recession wage growth is likely to accelerate albeit at rates lower than traditional economic recoveries.

Consumer disposable income - Growth in health care costs seems to be moderating, low interest rates are lowering borrowing costs for homeowners, increasing multi-family housing supply will eventually moderate rent increases.

Competitive threats - Macy's omni-channel strategy is aimed at providing viable options both in-store and online. Apparel often requires touching and feeling merchandise and is more difficult to disintermediate. Macy's is experimenting with a discount concept to compete against the off-price retailers.

Millennials - Some studies have reported that millennials prefer an in store experience, see link here: http://www.retailingtoday.com/article/study-younger-shoppers-want-stores

Shift in consumer preference toward experiences - We are monitoring the trend, but this novel theory currently is difficult to prove or disprove.

Too many stores/malls - We expect lower tier bricks and mortar retailers and malls to either shut down or restructure. This eventuality should benefit stronger, well capitalized players like Macy's.

Conclusion

In summary, we do not discount the many competitive challenges and structural headwinds facing traditional retailers. We believe expectations and sentiment for retailers remains at extremely negative levels and ignores much of the nuance found in a well-capitalized, asset rich, highly cash flow generative omni channel retailer like Macy's. We therefore believe the stock is priced for an unlikely worst case scenario. Any good news (real estate monetization, stable sales results) or lack of bad news will likely propel the stock higher. Management's proven track record of returning capital to shareholders via a 4.5% dividend and aggressive buybacks provides attractive support to the stock. Further, a proven activist in Starboard in an area where they've recently demonstrated success (real estate monetization) at Darden provides further confidence in Macy’s strategy and in upcoming catalysts. Finally, real estate value (after deducting for all of Macy's indebtedness) that exceeds market cap by 31% without ascribing any value for the cash flowing retail business provides a large margin of safety. 

Catalyst

Real estate monetization either through sales or joint ventures would generate additional cash to return to shareholders and provide further evidence of management’s commitment and success in unlocking shareholder value.

Stable or improving same-stores sales would highlight that Macy's business and free cash flow generation is not declining.

Completion of current $2B share repurchase authorization will demonstrate management's confidence in the business and their view that the stock is undervalued. We believe management will likely announce a new repurchase program after the current one is completed.

A dividend increase is likely given that Macy’s has increased its quarterly dividend six times in the past five years (750% increase) from $.05/sh to .37/sh.