|Shares Out. (in M):||337||P/E||12.0||11.5|
|Market Cap (in $M):||18,433||P/FCF||11||10|
|Net Debt (in $M):||6,421||EBIT||2,900||2,800|
Macy’s owns 77% of its 147,000 square feet of real estate but has historically traded in-line with peer retailers who rent all their space. Activists are currently urging Macy’s to highlight the value of this real estate for investors, which I think will drive the stock toward $85-100/sh, or 50-80% higher over 1-2 years.
Macy’s has owned most of its real estate for a long time, but the logic for highlighting that value is higher today for two reasons: (1) low interest rates have widened the multiple arbitrage, increasing the reward for SOTP valuation, and (2) Hudson Bay’s innovative transactions in Nov ’14 and Feb ‘15 created an easier way to credibly market the real estate to market than an outright REIT conversion, which reduces the costs & friction for Macys’.
(1) SOTP / Multiple Arbitrage
I see $17-21bn of real estate value in Macy’s $25bn EV. At $55/sh, I’m either paying (1) 6.5x EBITDA for the retailer and creating the real estate at a mid-teens cap rate, or (2) a 6-7% cap rate on the real estate and getting the retailer for 2x EBITDA.
One can also bridge the math from a multiple standpoint. Macy’s trades at 6.3x consensus 2016 EBITDA of $3.89bn, vs department store peers at 5.5-8x and specialty retail peers at 4.8-8x EBITDA. Triple-net and shopping center REITs trade at 15-21x EBITDA and 5-7.5% cap rates. For each dollar of EBITDA (rent) that Macy’s moves to an income vehicle, the unlevered market multiple expands 130-220%. At market rates, rents would consume 30-40% of Macy’s EBITDA, providing a 40-75% lift to the enterprise value.
There’s an ongoing debate about what Macy’s will look like in 5-10-20 years, but the market is very confident about long-term earnings power of A and B mall properties. Not to mention the differences in visibility, economic sensitivity, etc.
(2) Easier & more likely than before
Macy’s has always owned real estate and management has historically declined to highlight that value for investors. Even in the Spring of 2015, Macy’s told investors that they’ve looked at a REIT many times but weren’t interested because:
(1) Limited upside – as the single-tenant REIT/ propco might not get the full valuation of public peers
(2) Operating friction – in terms of (1) a cash rent burden on the retailer, (2) loss of the flexibility to close stores, and (3) additional leverage reducing M’s access to commercial paper.
(3) Management has also deflected REIT arguments by saying it’s a conversation about leverage, which it is not. It’s driven by cost of capital, and I’m not assuming that Macy’s increases it debt burden at all.
However, a number of things have happened recently that suggest management has changed their mindset and is actively considering doing something to highlight or monetize its real estate value.
First, Hudson Bay solved these problems by getting educated third parties (such as Simon Property Group) to mark ~90% of its real estate value to market, first in a mortgage and then in a JV. Importantly, the JV with Simon:
(1) Was nearly cash flow neutral, as the minority’s share of rent income was almost offset by the cash interest savings at the opco.
(2) Retained full control and operational flexibility to close stores. It also preserves the opco’s “piggy bank” of equity value, which Macy’s management prefers to keep as a cushion.
Hudson Bay’s mortgage and JV successfully highlighted the real estate value, giving sell-side analysts firm numbers to put in their SOTP models. Most of these analysts are understandably focused on the retail business, and probably prefer Simon’s valuation of the real estate to their own.
Second, activists have gotten involved. One can suspect they are pushing Macy’s to follow Hudson Bay’s playbook, taking out mortgages on its flagship properties and pursuing a JV to highlight the value of its many high quality assets. In May, CFO Karen Hoguet mentioned that Macy’s is “studying recent real estate transactions with bankers” and in August reiterated its ongoing strategic review: “the company has retained specialized real estate advisors, in addition to financial, legal and tax advisors, to intensely study its real estate portfolio to determine where opportunities exist that would further enhance the value of the company.”
I find the recent change in tone from management, the involvement of several well-respected activist investors, plus the compelling math to be encouraging. I think if Macy’s acts, it will try to showcase a majority of its real estate value, pushing the stock into the $80s.
If I’m wrong in my read of the tea leaves and management decides to keep managing the portfolio as it has in the past, I don’t see much downside from the current 11.5x 2016 P/E.
Recent IRS News
On Sept 14, the IRS said it is studying tax issues and will no longer issue private letter rulings (PLRs) assuring tax-free status for REIT spinoffs from non-REITs. Past spins have received IRS approval by attaching a small active business to the REIT (as a taxable REIT subsidiary, TRS), but the IRS is now reviewing (1) how active the spinoff needs to be (presumably >5%) and (2) whether there must be a business purpose for spinning the ATB/TRS specifically, which is unclear with Darden’s attaching six restaurants to its REIT.
The silver lining is that the JV structure isn’t affected by all of this. If Macy’s dropped real estate into a JV with a REIT as a minority investor, no tax is triggered and rental income is tax-free for the REIT.
In a bear scenario, the IRS could prevent an eventual tax-free separation of the JV (into a REIT), creating a tax liability of $5-8/sh. This math assumes that Macy’s tax basis on its real estate is 20-50% of market value and a tax rate of 35%.
Ø While Macy’s is viewed as “the best house on a bad department store block,” there are many challenges with owning the struggling/shrinking retail business. Some investors may want to hedge that piece and only go long the real estate stub.
Ø Higher interest rates could reduce the market prices for real estate.
Ø Macy’s current multiple could factor in some premium for real estate optionality, implying multiple compression if a transaction doesn’t materialize and multiple compression on the opco if it does.
Ø The IRS could decide to tax all future real estate separations.
Ø Conclusions from Macy’s strategic review, possibly in 4Q15 or 1Q16.
Ø 2013 – Canadian retailers Loblaw and Canadian Tire launch publicly-traded REITs
Ø Nov. ‘14/ Feb. ‘15 – Hudson Bay mortgages its flagship NYC store for $4bn and JV’s 52 properties at an average cap rate of 5.5%. The innovative structure marks the assets to market while retaining control, flexibility, and cash flows
Ø May ‘15 – On the 1Q15 call, CFO Karen says they’re getting questions on the real estate, are studying recent transactions with bankers, looking at the pros & cons of all the possible strategies and what is best for them. “Our objective is always to maximize value.”
Ø July ’15 – Activist Starboard Value Fund discloses a stake in Macy’s, saying the real estate is worth $21bn and the stock is worth $125. They look forward to speaking with mgmt. on the real estate.
Ø August ’15 – On the 2Q15 call, Macy’s reiterated that it is “intensely studying its real estate portfolio to determine where opportunities exist that would further enhance the value of the company.”
This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock. The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time.
Conclusions from Macy’s strategic review, possibly in 4Q15 or 1Q16.