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Shopping for Department Store Bond Values

Jeremy Glaser

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I'm here today with Joscelyn MacKay. She is a securities analyst here at Morningstar. We're going to take a look at department stores and explore some of the rating changes that she and her team have recently made.

Joscelyn, thanks for joining me today.

Joscelyn MacKay: Thanks for having me.

Glaser: So, let's take a look at some of the macro issues surrounding department stores right now. Obviously, consumer spending has come back somewhat from the recession, but are people really going to department stores?  Are they spending their money there?

MacKay: Retail sales growth has been strong since late 2010, and with consumer confidence improving and unemployment picture improving as well, we think those numbers are going to continue to go up.

Glaser: So, they are been getting a little bit more cash in their hands. What have they been doing with this money? Have they been trying to pay off debt or maybe investing in new stores? Where is that cash flow going?

MacKay: Well, during the credit crisis, I think, a lot of firms were really concerned with keeping their balance sheet stable. So, as we were still in the doldrums of the economic downturn, many firms were paying down debt really not focusing too much on share repurchase activities or dividends.

Glaser: So, if we look at across the entire spectrum of department stores who is doing better, who is doing a little bit worse?

MacKay: One of the firms that we really want to give a nod to is Macy's. They took on a large share-repurchase program prior to the downturn that really put their balance sheet in not very great shape. But we really have to commend the firm for the efforts that they have undertaken on both the merchandising side to improve their top line and margins and also on their debt side. They've paid down a lot of debt over the past year, and also they've really focused on reducing their pension liabilities.

Glaser: Who else has done a good job?

MacKay: Over the past year, I mean, we were concerned with Saks and Saks' performance. About a year ago, we rated the firm at that time as B credit. Margins were negative, and free cash flow was negative. And we were quite worried about their debt obligations.

Glaser: And they've since improved their outlook?

MacKay: They have. Their free cash flow is positive; they are posting positive growth. We really think they've worked on their merchandising effort, and their debt load has decreased.

Glaser: On the flip side, has anybody not been able to take advantage of this recovery and still looks like they could be trouble?

MacKay: Sure. We've been really disappointed with the consistent declines in same-store sales that Sears has posted, and we are really not very happy with how they've treated their debtholders. They've taken on $1 billion in debt last year, while we were still within the credit crisis, and that money went toward share repurchases and went to purchase some Sears Canada shares. On the positive side, they did reduce some of their pension underfundedness, but on the balance we really are disappointed by those shareholder-friendly activities, when their leverage is around 4 or 5 times.

Glaser: When looking at Sears, are you more concerned about the Sears brand-name stores, or with Kmart, or is it really a combination of both of them doing poorly?

MacKay: Yeah. It's really a combination of both of them. We are concerned that the sales growth has really not returned, and we are very nervous about the balance sheet and would prefer that the company take a little bit more of a conservative stance until they get their top line moving again.

Glaser: So, when you surveyed the landscape and did this updated take, where did you make changes? What did you keep the same, and where do you think you could make changes in the future?

MacKay: Sure. Our changes were reflected in those three names that I just mentioned. We upgraded both Macy's and Saks. We upgraded Macy's from BB+ to BBB-, which is that investment-grade/non-investment-grade cliff, and we upgraded Saks from B to BB-.

On the downside, we downgraded Sears from BB to BB-, and if the company does continue to slide that's a place where we would look to re-examine our credit rating.

Glaser: Given some of these new ratings, does that open up any opportunities for bond investors to maybe able to get little bit of extra yield without taking on a lot more risk?

MacKay: Our favorable view of Macy's has really been since prior to our upgrade. So we've really thought the firm traded much too wide for even its BB+ credit quality. The firm trades around the mid to low 300-basis-point range, which for a BBB- credit would really be closer to 200 basis points.

So, given the fact that this company has said that they want to be at investment-grade credit, they have talked the talk and they have walked the walk. They have reduced their debt obligations, and we think their leverage could get down to around 2 times by the end of this year. So, that BBB- level is really becoming justifiable, which means we think their spreads should tighten to around the 200-basis-point range.

Glaser: Joscelyn, thanks much for taking the time today.

MacKay: Thanks for having me.

Glaser: For Morningstar, I am Jeremy Glaser.