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Macy's Deflates, and Now It's Even More Undervalued

It's plagued by slow traffic and markdowns, but we think the dividend's safe.

Macy’s M share price dropped after the company reported second-quarter results and reduced its outlook for the rest of the year. We view the shares as attractive at current levels and believe the retailer won’t cut its current annual dividend of $1.51, which is yielding 9.3%. As we forecast Macy’s 2019 free cash flow at more than $1 billion, we think its annual dividend cost of less than $500 million is manageable.

Macy’s 0.2% growth in comparable sales on an owned basis in the second quarter came in below our forecast of 0.5%. Moreover, the company relied on significant discounting and promotions to sell slow-moving apparel, including private-label women’s activewear. This pressured the gross margin, which at 38.8% missed our forecast of 39.8% and represented a year-over-year decline of 160 basis points. We think the gross margin was negatively affected by both markdowns and e-commerce fulfillment costs. While Macy’s believes its inventory is in better shape headed into the fall season, it reduced its 2019 midpoint earnings per share outlook by more than 6%, suggesting a lack of momentum and lowered expectations for second-half operating income.

We think Macy’s operates too many stores that have too much selling space. It owns hundreds of stores in struggling malls, many of which may close. Macy’s, like J.C. Penney JCP and other department stores, continues to struggle with declining customer traffic due to competition from outlet stores, e-commerce, discount stores, and branded stores operated by vendors. According to data from the U.S. Census and others, department store sales in the United States have steadily declined since 2000. However, Macy’s has not announced another round of store closings and appears hesitant to do so. While the company owns potentially valuable real estate, its monetization efforts have stalled and were just $7 million in the second quarter.

We view Macy’s efforts to respond to competitive threats as promising but inadequate. We think its plans may improve sales at its leading 150 stores (which compose about 50% of total in-store sales), but we do not think they can bring customers to its hundreds of weaker stores in lower-tier malls. Among Macy’s efforts, it is expanding its Growth50 remodeling plan, improving its mobile e-commerce capabilities, expanding its vendor direct offerings, and continuing to open off-price Backstage stores. We view the last strategy as mostly defensive. Macy’s has opened 47 Backstage stores so far this year, bringing its total number to more than 200. While the company reports mid-single-digit comparable sales growth at Backstage stores open more than 12 months, we do not believe they are drawing traffic to the Macy’s stores that house them. Macy’s reported double-digit e-commerce growth in the second quarter, suggesting a decline in sales within its physical stores. Moreover, the company reported a 3% decline in average unit retail in the second quarter. We think the lower prices of Backstage items are hurting Macy’s pricing and gross margins and not driving significant incremental sales.

Well-Known Brands Can't Dig Moat We believe Macy's has no economic moat, as we do not think it has established a sustainable intangible asset or cost-based advantage over competitors. While its Macy's and Bloomingdale's brands are very well known in the U.S., intense competition from e-commerce and discount retailers has reduced mall traffic and eroded profit margins on many products sold in department stores.

As evidence of its inability to carve out a competitive edge, Macy’s adjusted returns on invested capital, including goodwill, have declined, averaging 13.8% for 2010-15 versus 8% for 2016-18. We do not expect Macy’s will generate economic profit after fiscal 2018. We estimate its weighted average cost of capital at 8.9% and forecast that adjusted ROICs, including goodwill, will average 8.3% in 2019-27. This supports our view that the company has no moat.

We believe Macy’s lack of an intangible-asset-sourced moat is reflected in the fact that it has been downsizing and plans further reductions in its store base and retail square footage. Also, Macy’s is a familiar brand, but it is not viewed as aligned with consumer trends, further supporting our contention that it lacks a moat based on an intangible brand asset. Our conclusion from a 2017 survey commissioned by the company is that many people know about Macy’s but prefer to shop elsewhere. The company has said that the average age of its customers is increasing and also that many customers do not buy much or visit often.

In 2017, Macy’s revealed that just 9% of its customers generate 46% of its sales on an average of 18 visits per year. It also said that 40% of these top customers drop down into lower segments on an annual basis, suggesting that its most important customers are not particularly loyal. Moreover, Macy’s statistics suggest that the bottom 40% of its customers visit fewer than three times per year and account for just 12% of sales. These numbers suggest that Macy’s is a well-known brand but not a particularly powerful one.

While Macy’s views Backstage as a major strategic initiative, we consider it mostly defensive. Macy’s knows that it is losing customers to discounters and is desperate to bring them back. Despite Macy’s claims, we are uncertain if Backstage is additive, as weak sales numbers have coincided with growth of the brand. It is possible that Backstage is cannibalizing full-price apparel sales. Also, we do not believe Backstage is bringing new customers to Macy’s stores. Backstage, unlike off-price stores located in strip centers, is as dependent on mall traffic as Macy’s itself. We do not believe Backstage will be significant enough to compete with discounters and strengthen Macy’s brand.

Macy’s sizable e-commerce business may also be taking sales from its physical stores. Macy’s has invested heavily in e-commerce, with an emphasis on mobile, same-day delivery in major markets, and buy online, pick up in store. However, it has been reporting poor same-store sales numbers even as its e-commerce business has grown, suggesting that e-commerce is cannibalizing its physical store sales. We do not believe Macy’s e-commerce contributes to the strength of its brand, as we do not view it as additive to sales.

Beyond intangibles, we do not believe any other moat sources can be applied to Macy’s. The company has no production cost advantage, as it sources its apparel from many of the same manufacturers as other fashion retailers. We do not believe it has the power to negotiate lower prices from producers. Macy’s does not have efficient scale, either, as its distribution system is like that of competitors. There is no network effect in the apparel retailing business and switching costs are nonexistent. While the Macy’s brand is widely known in the U.S., we do not believe it contributes to an economic moat and believe it stands to be challenged by the intense competitive landscape.

Recession and Trade War Could Hurt, but Shareholder Returns Intact Macy's, like others, is affected by the business cycle. In the last recession, its total revenue dropped from $26.3 billion in 2007 to $23.5 billion in 2009. Same-store sales dropped 4.6% and 5.3% in 2008 and 2009, respectively. Macy's sells clothing and accessories at all price points, including high-price luxury merchandise at Bloomingdale's, but unlike Nordstrom JWN and other rivals, it does not have a big presence in off-price fashion retailing.

Macy’s could suffer in a trade war with China. Clothing makes up around 70%-80% of Macy’s sales. As China accounts for 35% of worldwide apparel exports, according to the World Trade Organization, trade restrictions between the U.S. and China would affect Macy’s private-label and third-party apparel businesses. Tariffs on imports from China could increase Macy’s costs and hurt sales.

We think Macy’s has improved its financial strength through debt reduction, and we expect it to return significant cash to shareholders. Although we expect elevated spending from its Growth50 plan (about $900 million per year over the next five years), we forecast Macy’s will generate an average of $1 billion in annual free cash flow over the next five years. Macy’s continued to pay dividends through its debt-reduction period, having paid out about 40% of its earnings over the past five years. We expect its dividend payout ratio will average 45% over the next decade. Although Macy’s paused share buybacks in 2016 to prioritize debt reduction, it has been a consistent buyer of its own stock in the past (nearly $4 billion in buybacks in 2014-15 alone). Macy’s has reduced its share count by more than 30% since 2007. Overall, over the next decade, we anticipate annual dividend payments of about $450 million and annual stock repurchases steadily increasing to $500 million. Macy’s may return more cash to shareholders if it sells more real estate; it has realized roughly $1.3 billion in real estate sales gains over the past four years.

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