Conclusion: We’re bearish in light of a great quarter. A lousy secular story that a) is at peak margins and b) had a breakout year that temporarily pushed returns above its cost of capital, and c) is about to see a major competitor comes back online. The stock seems cheap, but not for a department store at peak margins and competitive threats looming. We think that anyone buying it here can at best be playing for a 10-11x pe on $4.25, or about 15% upside. On the bear side, we think you’ve got 8x $3.50 (our 2014 estimate). That’s 29% downside from current levels.
We find it hard to step up and be an incremental buyer of Macy’s here today. It has nothing to do with the quarter that the company posted, but rather, what Macy’s has to do from here to give us confidence in earnings upside.
As it relates to the quarter, there was hardly anything to criticize. M put up a solid 3.9% comp and leveraged that to 8% EBIT growth and 17% growth in EPS. We’ve often said that if we were given only one operating statistic about a retailer in a given quarter, we’d pick e-commerce sales. And Macy’s blew the doors off with 47% growth in dot.com. In the end, when we look back to guidance at the beginning of the year, Macy’s has done virtually everything it said it would do – and then some, winning some clear credibility in our eyes for a business that has hardly warranted much in the past.
We want to stay transparent and accountable on this one in that we’ve had it on our list of top three fundamental retail shorts throughout 2012, and the stock has worked against us over that time (+18% vs +24% for the S&P Retail Index). The part of the story that we missed was the acceleration in dot.com off of a larger base driving both comp and EBIT margin higher. We fared far better from a risk management perspective, going 5 for 6 in our Real-Time Alerts over the past nine months.
There are several reasons why we’re sticking with our short call.
1. Margins Are Toppy: First and foremost, Macy’s closed out this year with an EBIT margin of 9.6%. It touched that level in 2000, and then flirted with it again in 2004/05. Those were far better periods for the consumer than we’re seeing today. Admittedly, this was when it was a smaller and far less efficient organization (Federated and its predecessors). But even M mgmt noted that margin upside from here will be more difficult – in that weaker Gross Margins will be offset by SG&A leverage. Margins have gone from 5.6% to 9.6% over the past four years. That’s what made this stock go from 6 to 39 (yes, a 6-bagger). Margins might have a few basis points to go, but we don’t think Macy’s is a business that can sustain margins over 10%.
2. The JCP Factor: We think that another reason the stock worked in 2012 is because of the share gain from JC Penney. It’s kind of funny to hear M mgmt talk on the conference call that “the overlap isn’t 100%, and many of our customers are well above shopping at Penney.” We agree that the average Bloomies customer wouldn’t be caught dead in a Penney. But take a look at the chart below. It is the cumulative sales change for JCP vs M over the past three years. Can anyone really say with any iota of intellectual integrity that there has not been a material share shift? We’ve been big bears on JCP for 1.5 years, and turned positive on Dec 31. We think that the key at JCP this year will be turning the tip line. Even if they buy it – we think they’ll begin to close the competitive gap. Macy’s will still likely get their comp too, but we think they’ll take it on the chin with Gross Margin when all is said and done.
REVENUE DOLLARS HAVE CLEARLY SHIFTED BETWEEN JCP/M
3. Dot.Com: Again, hats off to M on this front. But by our math, dot.com now accounts for about 7% of total sales. That’s about in line with some specialty apparel retailers that offer a mono-brand experience directly to consumers – a model that presumably plays into e-commerce more easily. As M takes the number of stores that can fulfill orders from 292 up to 500, does that mean that dot.com should go up proportionally to 12%? It might, but it says nothing about their ability to continue to drive people into the stores. Also, part of Macy’s dot.com strategy is to allow consumers to order online and pick up merchandise in the stores. Seriously? Short of buying a 300-lb snowblower at Home Depot online and picking it up a few miles away, we can’t think of a single retail model where the ‘order online and pick up locally’ concept is additive. That might sound like a punitive statement, but we simply think that the big upside in omnichannel -- net of store sales -- has probably past. As a sidenote, management will no longer breakout dot.com from store sales. We've seen other retailers do this as well. And in fairness, it's probably the right move. But also means that its getting more mature and evolved.
4. The Big Picture: We all know that department stores have zero square footage growth. That’s no revelation. But longer-term, doesn’t the company need to find a way to make more people shop there? Ultimately, the more powerful brands (that currently sell wholesale inside Macy’s and other department stores) are incrementally going direct, and the ‘proprietary’ brands that Macy’s has are sub-par. Its boxes are massive – averaging 180k+ square feet – the largest out of its peer group. Also, it owns 55% of its stores, and some of the stores it does not own are on 100-year leases. The point here is that it needs to find ways to entice the next generation of shoppers to shop at its stores. We’re not sure if what we’ve heard of its Millennials strategy is enough.
Ultimately, we simply don’t like how this story is packaged. This is a lousy secular story with no unit growth that is at peak margins and just had a breakout year that temporarily pushed returns above its cost of capital. It has a major competitor that is coming back online after a disastrous year, and it will impact the competitive landscape whether it succeeds or fails in hitting its own goals.
Yes, the stock is cheapish at 10x management’s guidance for 2013. But it does not take a whole lot of historical fact-checking to see that department stores have traded at much lower multiples in the past. We think that anyone buying it here can at best be playing for a 10-11x pe on $4.25, or about 15% upside. On the bear side, we think you’ve got 8x $3.50 (our 2014 estimate). That’s 29% downside from current levels.