M | A Small Taste

Takeaway: A small taste of when the economy really weakens. Numbers still too high. REIT value no longer a crutch. This name can get a lot cheaper.

Conclusion: This might have been the longest Macy’s conference call in over a decade, but from where we sit, the conclusion on the stock is quite simple. Stay away from it. Is it an outright short? Maybe not after today’s steep sell-off. But we think that numbers are too high, even after the company’s guide down. At 10x earnings, 6x EBITDA, and a 9.5% FCF yield, it certainly looks cheap – but it had the same multiples yesterday before the earnings print. At this point, it’s all about earnings, and unfortunately, expectations for next year are high by over 10%. Consider the following:  a) we’re late in an economic cycle, b) the CEO just said it is the worst sales environment in 5-7 years, c) there’s no clear path to recovery (potentially ever), and d) one of the biggest bull cases (REIT) was just blown up. At this point, we think people are probably going to test the low end of the valuation spectrum until they have confidence that numbers have bottomed. For department stores like Macy’s, that’s 7-8x earnings, 4-4.5x EBITDA, and 15%-20% FCF yield. If our model is right, that implies a stock in the high-$20s. This is one we’re going to avoid, and will short on green as we gain confidence in our model.  

 

There was a lot of information in this print. Let’s focus on the Majors.

1)      Terry Lundgren Saves The Day – Kinda.  Macy’s CEO was on the conference call for the first time since 4Q09 – when he took a victory lap after implementing MyMacy’s as we emerged from the Great Recession. But this guest appearance by the man was anything but a victory lap. It was intended to be a fire retardant. It didn’t work.

2)      This Was All About Being Accountable to Activists. Let’s be clear on why Lundgren was on the call. It was not to discuss weak sales trends, strategic plans or financial results. Karen Hoguet (CFO) is about as savvy as they come, and could easily handle this on her own.  He needed to be on the call to be accountable to all the activist investors who have been in very close contact with Macy’s over the past year about converting into a REIT – something we’ve long viewed as financially and logistically impractical. Management stated as plain as day that Macy’s WILL NOT pursue the REIT strategy. This means if someone is invested in Macy’s for a REIT – and there are plenty who are – they probably need to either exit the position, or morph the thesis to be focused on the base business. But with sales down 5% and inventories up 5%, the company didn’t give a whole lot to get bullish about. Yes, Macy's contracted Tishman Speyer (the partner it used on the Brooklyn store) deal to find strategic/joint venture alternatives for 4 of its Flagship properties with the potential to touch more of the footprint as M rationalizes it's sq. ft. in those doors and attempts to creatively monetize a portion of its 'A' assets. But this is a far cry from monetizing 150mm square feet.

3)      The 5-7 Year Itch. Arguably the most troubling factor from our vantage point is Lundgren said "We believe that the retail industry is going through a tough period that we seem to experience something like this every five to seven years or so, and this one feels familiar in that regard."   He probably did not mean this to sound so dire, and softened it up accordingly after seeing the stock down double digits (his recoil didn’t work). But our concern is that growth is definitely slowing in the broader economy, and it appears to be very late-cycle. But it does not feel like a recession – yet. If Macy’s is putting up numbers like this and making these statements today, what happens when (not if) the US economy contracts again? We certainly don’t want to be there when that happens.

4)      Not a Likely LBO. One investor addressed LBO math in the Q&A. We happen to disagree, in that our model only comes up with a 6.2% ROI. There are actually a few things about the model that we like. a) at a 50% premium to current levels, M could be taken out with only $5.4bn in equity, assuming 50% is funded by Senior Debt and 30% by mortgaging its stores. That also gets us leverage of 3.8x, which actually quite good for such a large deal. The problem is that in order to get a 20%+ return – a level that’s a lot more palatable to us – we need to assume a reacceleration in sales and margins to new peak. In other words, we need to go another 5-years without an economic downturn.

 

M | A Small Taste - 11 11 2015 M chart1B

 

M | A Small Taste - 11 11 2015 M chart2