June 13, 2017 - 9:47am EST by
2017 2018
Price: 22.29 EPS N/A N/A
Shares Out. (in M): 307 P/E N/A N/A
Market Cap (in $M): 6,843 P/FCF 5.7 4.5
Net Debt (in $M): 5,525 EBIT 1 1
TEV ($): 12,368 TEV/EBIT 11.3 10.3

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  • Retail


Investment Thesis

With Macy’s (M) shares at 6-year lows and down 36% year-to-date, the stock offers a compelling opportunity for value investors. While retail has been a challenged business of late, particularly for companies that are mall-based, Macy's enjoys a significant margin of safety because its total real estate portfolio is valued at a multiple of its enterprise value and the company, even at reduced estimates, generates an 18% free cash flow yield. We exited our VIC buy recommendation for Macy's (please see 6/9/16 Buy report here: ) at $36 in early November 2016 due to concerns about the operating business. However, the recent sell-off in shares has created a compelling opportunity to own this world class retailer at a bargain price. We believe the stock can generate an attractive return for investors from either a) improved operating metrics off very low expectations or b) emergence of an activist or private equity player focused on monetizing the substantial sum of the parts value in Macy's. While Starboard Value estimated the total real estate portfolio to be worth $21B (or 1.7x current EV of $12B), there is $13 billion of value from just the Herald Square store, downtown Macy’s locations, and other owned stores in class-A malls. 


A recent Starboard Value presentation can be accessed here: On page 8, there is a real estate valuation summary by property type.


As such, we believe that the current sell-off in shares is over done and positions investors for a 25%+ return over the coming 6 to 18 months with a substantial downside asset value cushion. Management is actively monetizing real estate to pay down debt and executing on a merchandising turnaround, and the stock sports a healthy, currently safe 6.8% dividend yield.




Macy’s, Inc. is a department store retailer with approximately 840 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).



Capital Structure



Exhibit 1: Balance Sheet Overview


Source: proprietary estimates 



Market Overview

The department store industry has been in a downward cycle for the past couple of years. Store traffic is down, pushing same-store sales lower. Given this new reality for department stores and shopping malls, Macy’s and other department stores have announced massive store closures. For example, in January 2017, Macy’s announced that 68 stores would be closed in 2017 out of the 100 that were planned to be closed over a multi-year period. Further, the competitive landscape in apparel retailing continues to grow unabatedly. As a result, promotional activities are unlikely to relent for the foreseeable future and gross margins are likely to fall or stay flat in the near-term. With pressures on the top-line and gross margin, the retailers that are likely to survive and win in the long-term are those that successfully execute turnaround strategies with leaner, stronger brick-and-mortar store bases, more efficient corporate expense structures, and compelling omni-channel experiences.



Exhibit 2: Comparative Valuation

Source: Proprietary estimates for Macy’s and consensus for all others.

* All figures in $ billions, except per share data





Our Perspective  


Real Estate Value Offers Downside Protection  

We think some investors are discounting Macy’s significant real estate portfolio, rationalizing that declining mall traffic is devaluing commercial real estate. While we agree that this may be the case for some malls (location, mall type), for our analysis we are only focused on Macy’s best real estate. This includes the Herald Square (Manhattan) location, all downtown Macy's locations, and other stores in A++, A+, A, and A- malls. 



Furthermore, mall owners are not standing still. A recent Wall Street Journal article highlights efforts of mall owners to transform the mall experience into more of an urban-like environment complete with housing, services, and corporate offices. While the success of such initiatives is uncertain, current valuations do not appear to consider turnaround scenarios at either the mall or company level. 



Exhibit 3: Valuation of Macy’s Best Real Estate Assets


Source: Starboard Value; proprietary estimates



With these estimates for real estate value, Macy’s enterprise value is below our estimates for just Macy’s best real estate assets.



In 2016, Macy’s hired 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. Since then, Macy’s has formed a strategic alliance with Brookfield Asset Management for exclusive redevelopment rights for 12 to 24 months on 50 of Macy’s highest value real estate assets. The slide below from the company’s recent investor day depicts the types of projects that may occur:



Exhibit 4: Real Estate Redevelopment Opportunities

Source: Macy’s investor day presentation (2017)



Thus, Macy’s is considering redeveloping mall parking lots for other commercial uses. In addition, the company is considering creating a public park on the roof of its Herald Square (Manhattan) location, thereby attracting more traffic to this flagship store.



In 2016, Macy’s realized $673 million of real estate monetization proceeds, compared to $204 million in 2015. Thus, in the past two fiscal years, Macy’s has already unlocked almost $1 billion in real estate value. These transactions have included selling underutilized portions of store real estate in Brooklyn, Seattle, and San Francisco. For example, in San Francisco, Macy’s sold the Men’s Store building for $250 million ($1,000 per square foot). In addition, Macy’s has previously 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.



Even in down cycle, Macy’s generate significant free cash flow

As our financial model below indicates, even as we project EBITDA to be down 30% in F2017 from levels in F2015, we estimate that Macy’s will still generate $1.1 billion of free cash flow (excluding growth CapEx). Thus, we estimate a free cash flow yield of 18%. We anticipate revenue to be down 2.5% in F2018 and then stabilize to flat in F2019, consistent with an investment thesis that the next 12 to 24 months will continue to be times of transition and gradual stabilization. At the company’s investor day, management indicated that gross margin for F2017 would be down between 60 and 80 bps, due to necessary clearance initiatives. We think this positions Macy’s for gradual gross margin improvement in 2018 and 2019, especially as the company is embarking on a new merchandising strategy.



Exhibit 5: Financial Model



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

** Our EBITDA and FCF estimates do not include real estate monetization proceeds.



New Merchandising and Marketing Strategies Keys to Successful Turnaround

Macy’s is focused on revamping its merchandising strategy. In summary, the retailer is focused on unique and exclusive fashions, through partnership with its key suppliers (national brands) as well as private label. To this end, Macy’s is trimming its assortments to create a more curated, less duplicative, and more simplified shopping experience by decluttering the store. Further, this new strategy involves a renewed focus on fashion to further incentivize customers to shop the store. Thus, Macy’s goal is for private brand and exclusive assortments to comprise 40% of merchandise (up from 29% currently).



From a marketing perspective, Macy’s is focused on re-engaging itself with customers. For the all-important 18 to 35 year-old demographic, while 70% “feel good” about Macy’s, only 45% prefer or choose Macy’s as their favorite store. Thus, there is a 25 percentage point opportunity, which could significantly enhance business results. Further, Macy’s is focused on growing its loyalty by incentivizing customers. In a recent survey, Macy’s concluded that 9% of its customers account for 46% of its sales. Those are the retailer's most loyal customers. As a means to grow this customer segment, Macy’s will launch a customer loyalty program in the fourth quarter of 2017 with three tiers with varying benefits.



During the past couple of years, Macy’s has experienced success with various new initiatives. Thus, management does have credibility with recent programs. For example, the launch of Backstage, its off-price concept, is now exceeding expectations. For Backstage locations opened in 2017, the overall sales lift has been 6.4%, according to the company’s investor day presentation. This is in part due to 26% of customers shopping both Backstage and the main store in the same trip.



Attractive dividend yield further mitigates downside risk

At current levels, Macy’s sports a 6.8% dividend yield, with its annualized $1.51 dividend ($0.3775 per quarter). Management is committed to this dividend level. Therefore, we do not anticipate a dividend cut, especially given the considerable free cash flow generation even in the current operating environment.




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; f) perception that America is overstored and over-malled; g) potential for quarterly dividend to be cut or suspended.

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. 



Millennials - Some studies have reported that millennials prefer an in store experience, see link here:



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.


Quarterly dividend – While in theory there is a risk that Macy’s could reduce or suspend its quarterly dividend, we believe this is highly unlikely. As earlier detailed, Macy’s continues to generate significant free cash flow and will generate additional cash flow from real estate monetization. Further, management reiterated its commitment to its dividend during the recent investor day in early June 2017.




Even in the current weak retail environment, we think Macy’s stock looks attractive. As the retail industry completes a massive transformation over the next 12 to 24 months, with thousands of store closures, several more bankruptcies, and revised business models to reflect new dynamics, such as digital commerce, there will certainly be some winners who will emerge stronger than previously. We envision Macy’s being among those winners. With the leadership of Jeffrey Gennette as the new CEO, Macy’s is spearheading real estate monetization, as well as merchandising and marketing initiatives to engage stronger with customers and improve the overall shopping experience.



However, from a purely value perspective, Macy’s enterprise value is $12.4 billion, while we estimate the value of its best real estate at approximately $13 billion. The core operations trade at 5.4x EV/EBITDA (F2017E), which is attractive, as well. In addition, based on our F2017E EBITDA forecast, the company is levered at 2.4x, a reasonable level.



Finally, as the slide below illustrates, Macy’s leads its peer group in ROIC and cash flow generation and is near the top in EBITDA margin. As a result, this further provides confidence in the resiliency of Macy's and management’s ability to successfully complete its turnaround by navigating the current headwinds.


In summary, we expect that either the operational turnaround will bear fruit and propel the stock higher or an opportunistic player will emerge to extract value through the company's significant real estate portfolio. With expectations set low, even stabilization of the operating business should propel the stock significantly higher. In the interim, the company is opportunistically monetizing real estate to de-lever, generates an 18% free cash flow yield, is working to slash expenses and turnaround operations, and offers a healthy 6.8% dividend.


Exhibit 6: Comparative Valuation Metrics

Source: Macy’s investor day presentation (2017)





I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Real estate monetization either through sales or joint ventures would generate additional cash to return to shareholders and provide further evidence of success for the company’s real estate strategy. Specifically, new projects with the company’s alliance with Brookfield Asset Management would be a positive signal.  

Stable or improving same-stores sales would mark an inflection point to the upside for core fundamentals.


Accelerating digital commerce growth would provide evidence for Macy’s long-term growth strategy to truly be an omni-channel retailer that can compete effectively against players, such as Amazon.


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