Has Macy's Lost Its Magic?
Short-term cash drivers do not address long-term competitive problems.
Macy's (M) announced free cash flow drivers, including plans to remove $400 million in costs and to explore various possibilities to monetize real estate, may give investors hope for near-term catalysts and additional upside in the stock price. But although we agree that these measures have the potential to provide near-term upside, we think this upside is much more limited than many investors are estimating, and the long-term implications of both measures could even be negative. More important, neither of these measures addresses the fundamental operational issues plaguing the stock, namely a category in secular decline and a business with few defenses against new competition, the basis for our no-moat rating. Ultimately, we think Macy's is fighting an uphill battle, and even if new operational strategic initiatives are effective, they are likely to be multiyear investments before having a noticeable impact on returns.
Cost cuts include consolidating Macy's stores into five regions from seven, adjusting staffing levels, implementing a "voluntary separation opportunity" for some senior executives, reducing back-office positions, consolidating credit and customer services centers, and decreasing nonpayroll budgets. We fear that such measures could have a negative impact on customer experience by making localization efforts more difficult in a consolidated operating structure, making service and neatness more challenging with decreased staff in stores, and increasing wait times or lowering performance for call service in consolidated customer services centers.
Little Room for Market Share Gains in a Declining Category
New distribution channels and retailing models including e-commerce, off-price retailing, specialty cosmetic stores, and flash sales have had a tremendous impact on department store market share. Using data from the Department of Commerce, we estimate that total department store market share has fallen to 3.6% of total retail sales from 5.2% during the past five years alone. This implies that department store sales have fallen at a 2% compound annual rate over the past five years, versus general retail sales that grew at a 5% compound annual rate over the same period. Although there are periods of recovery in volume growth (in 2014 and 2015, for example), they were at the expense of heavy discounting and promotions. Overall, changes in pricing have done little to move the needle on sales growth.
We don't see this trend changing, as there are few barriers to entry and Macy's is now competing with businesses with a cost structure better aligned with low pricing. In our opinion, department stores will continue to post growth at the same discount to overall retail sales as in the past. This leads us to an assumption of a negative 3% department store compound annual rate over the next five years. This assumes that department stores are able to better manage inventory to limit discounting and inflation will stabilize pricing. Our volume decline assumption reflects our belief that foot traffic to malls will continue to fall.
Given this secular decline, we think Macy's will be more reliant on possible consolidation, diversification of business lines, and market share gains from competitors to drive growth. This is apparent in the company's strategic initiatives. However, we think many of these initiatives will take time to affect performance. We model comparable sales growth to slightly outperform the industry, thanks to Macy's strong brand and retailer relationships, but still trail overall retail sales growth over the next five years.
Consolidation Brings Economies of Scale
but Also Oversize Brick-and-Mortar Presence
In the past, we thought that scale yielded a competitive cost advantage and a unique network effect, making acquisitions a common practice. Although we believe economies of scale still yield a competitive advantage, we think the resulting brick-and-mortar presence is too large for modern shopping trends including e-commerce, omnichannel, and speedier delivery possibilities. Overall, economies of scale have not been strong enough to warrant an economic moat.
The larger the department store, the greater the bargaining power with suppliers. This benefit came not only in the form of cost advantages through practices like volume purchase discounts and buyback clauses but also in product selection, as larger companies were sometimes able to convince suppliers to offer merchandise exclusively through them. It is difficult to gain an exact understanding of the monetary value of these economies of scale because each vendor contract is unique. However, we can glean some understanding through anecdotal evidence from vendors. Martin Lehman, a volunteer with SCORE (a national organization that provides business counseling for entrepreneurs), provided an example of dealing with big-box retailers to Entrepreneur.com. In his example, an item that sells at retail for $4 may sell at wholesale to boutiques at $2, but a big-box retailer may only offer the manufacturer $1.25. Alan Zell, who worked for more than 25 years in his family's fine jewelry business and then as a retail industry consultant, said discounts, including advertising, freight, shrinkage, and anticipation, can shave 15%-20% off a vendor's invoice. He also pointed out that these larger retailers can have long payment windows.
We think such bargaining power was meaningful to Macy's competitive advantage. Mazzone & Associates, a mergers and acquisitions advisory firm, estimates that product purchases account for more than two thirds of big-box and department store retailers' segment revenue on average.
Scale also probably yielded a small network effect in pre-e-commerce days. National broadlines companies could have been viewed as a more attractive option for gift-giving and registries as the plethora of stores across the country made for easy purchasing, returns, and exchanges no matter the location of the purchaser or recipient. The stores also carried a broad swath of brands and categories, giving gift recipients even more flexibility in obtaining what they needed.
As a result of these benefits, industry consolidation reached high levels. The 1900s and early 2000s saw large national department stores acquiring regional players. Two of the largest department stores--Federated and May--combined in 2005. After actively participating in M&A activity, Macy's now reigns as the largest department store.
Although we agree that scale made sense in the historical retail environment, we think this exact trait not only is a less defensible competitive advantage in the modern retail environment, but also has hindered department store efforts to continue to be relevant. In our opinion, too many stores and a complicated supply and distribution system have made these companies less nimble to cope with the multitude of new challenges, especially the addition of the e-commerce distribution channel.
With customers now shopping online or pre-shopping online and picking up in stores, and with local delivery from stores now possible, the need for multiple stores and sizable square footage for stocking inventory has fallen. We think over time stores will be spaced farther apart and used more for showroom purposes to convey the brand and display products. We see most inventory being moved to cheaper warehouses from which deliveries can be made to both in-store and online customers.
Macy's store productivity reflects our belief that stores have sometimes become more of a hindrance than an asset. Over the past five years, sales per square foot have barely increased despite the inclusion of higher growth e-commerce sales and the company's efforts to continually trim square footage. Macy's does not break out e-commerce sales, which we think makes sense given that many customers use online and brick-and-mortar channels in combination to make purchasing decisions. However, declines in sales per square foot despite the tailwind of additional e-commerce sales are a red flag, in our eyes.
In light of this, we think Macy's recently announced closure of 35-40 stores by the end of 2016 is strategically sound. In aggregate, we now model about 5% of the current Macy's store base to close, resulting in the loss of $300 million in revenue (roughly 1% of total revenue). However, given continued shifts to e-commerce and market share losses to competitors, we think these cuts are not deep enough. We think square footage declines--through store closures or store size reductions--should come close to matching online penetration levels. As such, we think about 100 store closures over the next five years would have a positive impact on productivity.
Investments in Higher-Growth Business Necessary but Time-Intensive
With core department store sales in apparent secular decline, Macy's has turned its attention to other growth avenues. In March 2015, Macy's acquired Bluemercury, a luxury beauty product and spa retail chain. We think this acquisition made sense; it allows Macy's to recapture some of its business as consumers have shifted from department store cosmetic purchases to specialty retail outlets and off-mall stores, including Bluemercury and Sephora. However, Bluemercury has only 77 specialty stores, with much smaller square footage than Macy's department stores. The deal was valued at $210 million, versus Macy's $28 billion in revenue in 2014. Given Macy's scale, acquisitions will have a difficult time moving the needle.
Macy's is also investing in an off-price concept called Backstage. The draw is obvious: While Macy's comparable sales growth has averaged 2% over the past five years ended in 2014, Ross' (ROST) and TJX's (TJX) comparable sales have grown 4% on average annually. Additionally, most competitors have already pursued the model with Nordstrom Rack (JWN), Off Fifth by Saks, and Neiman Marcus' Last Call.
However, the success of this strategy for Macy's is questionable. First, Macy's already offers discounts to full-priced national branded apparel, making the differentiation between its core stores and this new concept more difficult to define. Second, the space is becoming very competitive. Ross and TJX are expanding their store bases at a mid-single-digit clip, and Nordstrom has been rolling out Rack stores at a double-digit growth rate. Coupled with the possibility that consumer preference for the off-price retail model may slip in the future as trends and wage growth shifts, Macy's may not see the same success that the industry has in the past. Finally, Macy's is growing this concept organically, and we think it will take time before any new concept can have a noticeable impact on performance.
Real Estate Has Value, but Likely to Be One-Time Gain
Under pressure from activist investor Starboard, Macy's is considering options to unlock the value of its real estate portfolio. After rejecting the formation of a real estate investment trust, Macy's engaged Eastdil Secured to work with it, Credit Suisse, and Goldman Sachs in considering partnerships or joint ventures for its flagship real estate and mall-based properties. The company has other advisors reviewing other possible methods to monetize the real estate portfolio. Starboard estimates the total value of the portfolio to be $21 billion with a premium valuation for flagship city locations.
According to Starboard's proposal, the key feature to unlocking this value is the formation of two joint ventures, one for iconic properties and one for mall properties, jointly valued at $16.5 billion (this is lower than the $21 billion referenced above as it excludes owned mall stores in C locations, Portland, Brooklyn, Seattle, ground leased mall locations, and owned distribution centers). Second, Starboard assumes that a partner will assume 15% ownership of the joint venture for $1.7 billion in cash. Third, Starboard assumes the joint venture takes on initial leverage of 5.8 times net debt/EBITDA, which enables Macy's to repay debt at the parent level to achieve leverage of 3.5 times adjusted debt/EBITDAR. This is above Macy's stated 2.8 times target, but Starboard thinks this could be addressed by funneling joint venture cash flow back to the parent. Starboard also assumes that Macy's can maintain 95% of its current cash flow through distributions from the joint ventures. Macy's can choose to have the joint venture either distribute its cash flow back to Macy's and its real estate partner or retain the cash flow at the joint venture level. Given these assumptions, Starboard estimates about $24 upside per share.
We think Starboard's calculations are aggressive. First, we think the deal would need to be structured such that the partner would be the managing member of the real estate portfolio. We think this would be necessary so that Macy's stake would be accounted for by the equity method versus consolidation, which we see as key to allowing for additional leverage in the joint venture (5.8 times net debt/EBITDA or $6.9 billion) without affecting the firm's investment-grade credit rating. Macy's has publicly stated its intention for a 2.8 times target ratio; we think this is essential to its operational execution as many vendors rely on factoring and an investment-grade rating is necessary for this.
Although this arrangement would make sense for financial structuring, it might also mean that Macy's would give much operational control of the real estate to its partner. In the Hudson's Bay/Simon Property joint venture trust structure, Lord & Taylor and Saks Fifth Avenue entered into individual triple-net master leases at the time of the loan closing, with initial 20-year terms and six individual 5-year extension options. Leases included a provision for 2% annual increases in base rent, and the tenant's obligations under these leases were guaranteed by Hudson's Bay.
Second, in the proposed structure, Macy's would receive $1.7 billion from the sale of 15% of the joint venture to a partner. But if the deal were simply structured so that Macy's paid long-term rent back to this entity, the transaction would be roughly value neutral on a discounted cash flow basis. The only way we see Macy's recognizing this as a long-term gain is if the property is transferred to a new tenant (such as commercial offices or condos) that has the capability to generate a higher return. Even then, some of this gain would be offset by lost revenue as the pre-existing Macy's store ceases operation.
We agree that some square footage is underutilized and Macy's may see a higher return by allowing someone else to use the space. We just don't think this is true across all properties. In our model, we assume that Macy's is able to transfer about 15% of its square footage to another operator with very little impact on sales.
Using these assumptions, we think the joint venture would yield $12 upside to our discounted cash flow analysis. The stock may see some additional short-term upside through multiples analysis if the company uses the funds to repurchase shares, but overall, we find estimates of upside through a joint venture to be vastly overstated.
Our Fair Value Estimate Is $44
In the long term, we believe that monetization of real estate, store closures, and cost cuts will provide margin support, but regaining market share in a highly competitive space will be difficult to achieve, especially given that we think Macy's lacks an economic moat. Thus, we have Macy's continuing to trail overall apparel market growth. Our $44 fair value estimate is based on a discounted cash flow analysis using a 7% weighted average cost of capital.
We expect revenue to decline 2% in 2016, with a 2% same-store sales decline and an almost 1% decline due to the announced 40 store closures. Because we think store closures of some of the much larger Macy's stores will more than offset the addition of the comparatively small Bluemercury and Backstage stores, new store growth is a drag to revenue. Overall, we model the operating margin to decline 40 basis points to 8.2% as a 40-basis-point increase in gross margin (from less discounting) and benefits from cost-saving initiatives and real estate transactions are offset by further investments and deleverage. Our estimate includes $400 million in cost savings and asset sale gains of $235 million. We see earnings per share reaching $3.82.
During the next five years, we expect Macy's revenue will be roughly flat on average annually on flat comparable sales growth and further store closures (the 40 already announced plus our assumption of 60 more). We expect Bluemercury to be the biggest contributor to new store growth and is much smaller in selling square feet. We model store closures tapering off in 2020. We think operating margin will recover to 9% by 2020 (versus 8.6% in 2015) as cost initiatives and store closures improve profitability.
Bridget Weishaar does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.