M | Sleight of Hand

Takeaway: Macy’s business model is a short from where we sit. Unfortunately the stock probably isn’t.

Conclusion: Macy’s business model is a short from where we sit, but the stock probably isn’t. It took down 2H expectations to a point we think is doable. Until then, there’s a perceived call option on real estate value – even though we think that’s a bad idea for M.

DETAIL

Everything about Macy’s quarter screams “late cycle”. The -1.5% comp de-levered into -24% decline in EBIT, and a 38% decline in Cash Flow – despite a 7% increase in credit income (extra $0.02 per share – now 30% of EBIT). That’s the worst performance we’ve seen out of Macy’s since 1Q09 – when we were knee deep in the Great Recession. There was a clear note of caution about softness in the economy, which is the second time we’ve heard that in as many days from a retailer that missed (Hibbett being the other).

Despite the weakness in 2Q due, in part, to general softness in the economy, the company noted that Back-to-School started off well. But that’s something we take with a grain of salt, as the company (and others) almost always say that they’re pleased with initial trends – if nothing else, from a PR perspective.

In fact, just last year Macy’s said...

“Well, the end of the second quarter, back-to-school was extremely strong at the start. We will see as it goes through the season, but we feel very good about it.”

Only to come back 13 weeks later to tell us…

“We were disappointed, however, that we did not sustain the momentum of the strong start to our back-to-school business...”

Guidance for the remainder of the year is a mess. The company actually held its annual constant, but now that includes a $250mm gain on property sale – part of which appears to be from future expected cash flows. So that’s about $0.46 per share. When we back out the $0.12 2Q miss, it suggests that – on an operating basis – 2H numbers are coming down by $0.34, or 10%.  This isn't a slam dunk by any stretch, as it suggests 8% 2H growth excluding the gain on sale, which compares to -15% in 1H. But with the excess inventory Macy's is sitting on (see SIGMA below) its likely to drive comp, albeit at lower margin.

M  |  Sleight of Hand - M sigma

There’s one area, however, where we give this management team all the credit in the world (aside from financial engineering). It’s knowing what to say and do to take investors’ attention off the key issue at hand (weak core). Today that took the form of two separate press releases regarding 1) an e-commerce joint venture with Li & Fung/Alibaba, and 2) The renovation and partial monetization of a downtown Brooklyn property. Neither of these two are material to results, but the headlines suggest otherwise. Also, management said enough to keep the activists at bay as it relates to monetizing large parts of the real estate portfolio. That subsequently keeps a bid on the stock as hope springs eternal for a Macy’s REIT (see below).

Despite the weakness in the quarter and the major structural issues plaguing its business model, we don’t really consider this one a great, or even a good, short from here. It appears cheap on earnings and cash flow, and there’s a definite call option on store monetization. We’re simply avoiding it on both sides until we see a change in the research, the price, or both.

HERE’S WHAT WE SAID ON 7/16/15 AFTER THE REIT ISSUE WAS PUSHED INTO THE FOREFRONT

Takeaway: We don’t dispute the M REIT math. Just because it could happen, does not mean it should.

We want to be clear about where we stand on the whole Macy’s REIT issue.

Up front let’s just say — it makes sense. When this became a potential issue six months ago, we removed the name from our active short list.  Note that as it relates to this week, the concept of a REIT is not new. The only new component is Starboard going activist on making it happen two days after Macy’s sold off a store in Pittsburgh.

We want to be crystal clear that the way to be positioned in this space into our #growthslowing Macro call is to be short KSS. There is ZERO potential for Kohl’s to be monetized as a REIT.

There Is Zero Real Estate Play At KSS.  The same strategy that gave KSS the upper hand in a pre-Internet era is the same one that takes away any optionality on a take out. It’s real estate is worth very little. The company owns 413 out of its 1164 stores. But they are almost entirely located in strip centers. JCP, for example, has 140 stores in ‘A’ malls (the top 300 malls in the country). KSS has less than 10.  When you look at the economics, there are 1100 regional malls, and there have been maybe 5 built over the last decade. If you are a retailer who owns a piece of that real estate (the equivalent of beachfront property – there’s simply no more being made) then you’re in luck. But there are 7,000 strip centers. They’re literally a dime a dozen. Using the same metaphor, it’s like having a beach home, but being a half-mile walk to the ocean.

As it relates to Macy’s there are a few considerations.  

1) First is that we don’t think that the property values argued by Starboard are egregious. Keep in mind that Saks recently monetized its 5th Ave store for $3.7bn. When we look at Macy’s Herald Square, Chicago, and San Francisco properties, we don’t dispute that we could be looking at $6bn+ in value right there. 

2) But, and this is a HUGE but…These exceedingly valuable properties are currently a massive freebie. Macy’s pays zero rent on them. Unless you want to assume that the operating company goes away — i.e. is worth zero — then Macy’s has to pay rent back to the future landlord. The more valuable the property is, the higher the rent, and the lower the margins. A $24bn value in the analysis below suggests that Macy’s would have to pay about $1.5bn in extra rent. Do you really want to cash in the crown jewel assets of an uber-cyclical and levered business, weigh it down with rent occupancy payments, potentially buy back stock (as some are arguing to us) at the top of a growth and margin cycle — only to leave Macy’s with no levers left to pull when the environment inevitably goes the other way? Yes, you’ll have sold assets at the top, but will have locked in rent at the top too.  

3) The CEO and CFO at M are easily the most financial savvy executives in all of retail. If doing this kind of deal made sense, we think they’d probably have done it already.  That said, CEO Lundgren has maybe a year or two before retirement, and Hoguet (CFO) has maybe a couple years more. This could potentially alter their appetite for a deal as it relates to creating a legacy. We’re just not so sure that’s the legacy they want to create.

4) If a deal comes to fruition, we wonder who will be on the other end? We know for a fact that there’s a market for one-off properties — like Macy’s Pittsburgh property that it monetized earlier this week. In that instance, Macy’s sold it and exited the market. It didn’t belong there. We’ve also seen instances where several stores were sold at a time. But 446 stores worth 89mm square feet and 5% of total apparel and accessory retail space in the US? We be really interested to see how liquid the market is for that kind of space.

M  |  Sleight of Hand - M realestate value