Macy’s (M) has been struggling for years, which did cause a real overhang on the shares. This was of course driven by a combination of modest declines in sales and real margin pressure, yet I always believed that pulling the real state card and the subsidy from cheap real estate will result in a situation in which value for shareholders could be delivered.
After two dismal quarters following Covid-19, the situation has become much more challenging and far less compelling, although there are some silver linings as well which make the story still very interesting to watch.
As mentioned, Macy’s has been struggling over the past decade as sales have risen from $25 billion around 2009 to a peak of $28 billion in 2013/2014 before falling back to $25 billion again in 2019; 2020 will be a strange year for obvious reasons. Years of cumulative inflation chip away at margins at the same time as sales have been flat for a decade. This has resulted in operating margins falling from $2 billion a decade ago and nearly $3 billion at the peak to just around $1.2 billion in 2019.
Despite a steep dividend yield and the fact that nearly 30% of shares were repurchased over the past decade, the company still managed to cut net debt from around $6 billion to $3.5 billion over the past decade, and this has been a lifesaver following the outbreak of Covid-19.
The initial rise from 2009 to 2013/2014 and the sequential decline in the fortunes of the company have been well reflected in the share price. Strong momentum resulted in the shares rallying from $20 to a high of $70 in 2015 (with shares peaking, as activist investors were advocating the real estate ”card”), and they’ve now fallen back to just $7.
2019, A Base Case
The title of this paragraph is a bit misleading as the company has been battling continued headwinds from discounters undercutting price and e-commerce having broader assortment for years. Last year, the company reported a near 2% fall in sales to $24.6 billion, and while sales were down just $400 million in dollar terms, margin pain was observed. Adjusted EBITDA fell more than half a billion to $2.3 billion, and this decline actually outpaced the dollar amount in sales reduction! Reported EBITDA fell by $0.7 billion to $1.9 billion.
The company reported adjusted earnings of $2.91 per share, down substantially from the $4.18 per share reported in 2018. Net earnings came in at $1.81 per share with the majority of the discrepancy stemming from restructuring charges, quite a charge for the business in its situation. Net debt of $3.5 billion seemed reasonable given the EBITDA numbers, although it gets dangerous if margins narrow to a situation in which the D&A component explains most of the EBITDA number.
This was reflected in the shares, as they entered 2020 around $17-18 per share. The valuation multiples were low, yet few triggers were on the horizon as management did not seem willing to pull the real estate card and it guided for adjusted earnings to fall further to $2.67 per share in 2020.
Included in these earnings guidance is a big subsidy as large parts of Macy’s real estate have been owned for decades or nearly a century. This causes a low value, which provides a real subsidy to the operating business, providing a competitive advantage to many peers. Despite the low valuation of older buildings, total real estate still represents a book value of $6.6 billion.
This internal real estate business provides a big boost to the reported income (as competitors have to pay steep rent and Macy’s only has to pay relatively low interest on modest debt). Even if Macy’s reports operating margins at the mid single digits, the operating business is not really earning money and the company might be better off becoming a REIT, if not for the fact that the retail sector was facing such a dire outlook.
This original thesis, one of constructive optimism on the back of the valuation but mostly the real estate angle (with estimates in the past suggesting billions of hidden real estate value), can be thrown out of the roof (at the very least temporarily) after Covid-19 arrived. After all, department stores are hit among the hardest due to their location, size, assortment and relevant categories.
First-quarter results, for the quarter ending May 2, were obviously very weak for obvious reasons, which impacted the business for roughly half the quarter. Sales fell 45% to $3.02 billion, representing a $2.5 billion fall in sales in actual dollar terms. Adjusted EBITDA losses came in at $689 million, a $1.14 billion reduction on the back of the reported fall in sales, quite some deleveraging. Of course the company reported a huge loss related to impairment and restructuring charges.
Net debt rose to $4.1 billion on the back of the losses and the increase in working capital, and while inventories fell in dollar terms, they were up in relation to sales. Expectations went through the floor as the 310 million shares still represented more than $5 billion in value at the start of the year, yet having fallen to a low at $4 and change at the darkest hour of the crisis, they represented a value just in excess of a billion!
Early September the second-quarter results looked relatively okay. Second-quarter sales fell 36% to $3.56 billion, down $2.0 billion in dollar terms. An adjusted EBITDA loss of $142 million translated into a $544 million reduction compared to last year. The impact of cost cuts and slightly lower decline in sales marks for a real improvement compared to the first quarter.
Digital sales were up 53%, which stands in sharp contrast to the triple-digit growth numbers reported by many peers. On the other hand, digital sales now make up 54% of total sales, implying it was a $1.9 billion quarterly business. This essentially reveals that digital has grown from $1.2 to $1.9 billion, revealing that store sales fell from $4.3 billion to merely $1.6 billion! This 61% decline is confirmed by the management, although the exit rate at the second quarter had improved to minus 40%.
The high penetration of digital sales makes it hard to grow (Nordstrom (NYSE:JWN) for instance has a similar sized e-commerce business with hardly any growth in this environment), yet it reveals the extent of the turmoil in the physical stores as well! Net debt fell a bit to $4.0 billion thanks to moderating losses, good inventory management, and some lease liabilities being deferred.
The situation is very delicate of course driven by the crisis, but there are few things to like, and those include the rise of e-commerce and the fact that more unprofitable stores can and will be closed. Furthermore, the urge is felt in the organization, and some wild cards like real estate monetization might be discussed right now, as the real estate markets are in real turmoil as well, including Macy’s very important market of New York.
Additionally, I take comfort with the guidance calling for sales to be down 10-20% in the fall season and sequential improvements in EBITDA in Q3 and Q4, with a positive number expected in the final quarter.
On a price trading action side, I recognize that many peers have now topped the momentum-induced highs in June, especially if they operate in the right categories, while Macy’s shares have been lagging quite a bit. Hence, I am happy to have a long position, offset by some general market shorts and other retail shorts.
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Disclosure: I am/we are long M. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.