M | “Move Along, Nothing to See Here”

For every reason we find to own Macy’s, we find another five against owning it. This quarter was just horrible for Macy’s, and what’s even more concerning is that it’s the best-managed name in the ‘space’. Last night Dillards printed its biggest EBIT decline in 5 yrs. What does it mean for KSS? JCP? What especially concerned us with Macy’s was the lengths it had to go to find earnings outside of what we’d consider its core business.

Things That Caught Our Attention In Macy’s Quarter

1. Remember this print when looking at Retail for 2016. We think much of retail will look like Macy’s in 2016. After a serious guide down (and 33% draw down), the company came back with a significant headline beat. As the release hit the wires this morning we saw ‘Blowout Quarter’ by one unnamed news service. The reality is that companies are guiding down more than they have to, simply because they can’t plan the demand side of their businesses.  That’s not because of lack of competency, but simply because this is Retail (and sometimes lack of competency). Then they come in and print a horrible earnings/cash flow algorithm, but it’s viewed as being ‘better than expectations’. Our concern has been that the market will still trade these names higher. The Macy’s print – thankfully – argues against that.  
2. What Business is M In Anyway? For the first time ever, real estate and credit were the largest part of consolidated EBIT. And that’s a big statement. On a GAAP basis, including the asset impairments/restructuring costs, credit card income and real estate transactions amounted to $1023mm for the year – that’s 50.2% of EBIT vs. $860mm or 30.7% of EBIT last year. Though we think there are risk associated with each piece (credit and real estate), the fact is that M has them and the rest of its peer group and other retailers do not.
3. Credit profitability guided down for 2016. In FY15 we saw credit income up 7%, and +17% in the 4^th quarter. The big bump in 4Q was due to the conversion of new system allowing M to reach lower in the credit standard barrel. But, Karen was very explicit that about the embedded risk to profitability in the Credit segment as we come off all-time lows in charge offs and delinquencies. For M, credit amounted to an $831mm offset to SG&A for the year or 36% of EBIT vs. 27% of EBIT last year. Put another way, that’s 94% of the FCF generated by M this year.
4. The bigger callout here is KSS. Which, unlike M doesn’t have the benefit of taking its credit standards any lower – it already did that under the partnership agreement with CapOne as it took credit as a percent of total sales from 50%-60%. Its own credit portfolio will fall victim to the same profitability concerns expressed by M’s CFO today. Plus, we see additional credit risk because of the introduction of the Y2Y rewards program nationwide in the fall of 2014.
5. Outlook for the first nine months of the year notably bearish. There is a mismatch here between what the company could say because of the sentiment surrounding the department store space and what it’s actual outlook is for the year. But, either way we slice it, M guided to negative comps for the first 3 quarters of the year, and we expect to see more of the same from retailers in this earnings season. Though consensus numbers don’t reflect the guidance revisions.
6. Huge ‘Real’ Earnings Delta. We can’t remember a quarter where the difference between adjusted earnings numbers and GAAP numbers were more pronounced. We’ve never agreed with M’s adjusted financials where it sheds the bad (restructuring/store closing charges) and keeps the good (asset sales) in its calculation of adjusted EPS. Neither has proved to be one time in nature. When we boil it all down we get to an earnings growth rate of -22% in the quarter vs. -14% reported, that excludes the asset benefit and restructuring charges. SG&A growth was flat vs. -5% reported (ex. credit benefit, restructuring, and asset sales).  Neither of which provides a good omen for the rest of the space.
7. In a Hole. We understand that business improved as the quarter progressed due to added markdowns and better weather, but why do inventories remain so out of whack? SIGMA chart below suggests that inventories are not being cleared fast enough, or that price cuts are not deep enough. This definitely puts Macy’s in a hole in 1Q.