Macy's Insecure Covenants: The Goodwill Trap

Macy's (M) carries a large debt burden of $9 billion in large part due to its acquisition of May's Department Stores in 2005. Its operating margins have fallen to 1.24% and profit margins to -0.8%. Should investors be worried?

Several analysts present during Macy's most recent call expressed concern about Macy's "tripping" its debt covenants. During Macy's Q3 conference call, CFO Karen Hoguet felt the debt covenants were secure.

Howard Bryerman – Evergreen Investments

Could you just refresh my recollection of what are the bank maintenance covenants?

Karen M. Hoguet

There are two covenants. One is at EBITDA to interest, which is set at 3.25. And as of the third quarter that calculates to 5.06. And a leverage test, where the covenant is .62 and again, it calculates to .49.

The leverage test applies the formula: net consolidated debt/ net consolidated debt plus share holder equity. Net current plus long term debt was $9.834 billion at the end of Q3. Share holder equity was $9.690 billion. Therefore, the ratio is 9.834/9.834 + 9.690 = 0.49.

Ms. Hoguet is correct. The covenants are "technically" in compliance. However, the leverage test depends heavily on shareholder equity. If this value declines enough, Macy's breaks their loan covenants. So what makes up the $9.690 shareholder equity? At the end of the third quarter, its $9.690 share holder equity includes $9.870 billion of goodwill and other intangible assets, a sum in excess of the total equity position. Much of this goodwill includes the very significant amount Macy's overpaid when it acquired May's Department Stores. From January 2005 to January 2006, goodwill and other intangibles jumped over $9 billion. Take away their goodwill and other intangibles and the shareholder equity is wiped out.

The question is: how dependable are those goodwill and other intangible assets? Macy's periodically must reassess the true value of these assets that are being carried on its balance sheets (see here). Under current retail market conditions, it would seem that the goodwill and other intangibles have greatly eroded in value. It seems hard to place real value to the $9.397 billion goodwill and other intangibles added to Macy's balance sheet for purchasing May's Department Stores. If and when Macy's recognizes an impairment of its goodwill assets, its loan covenants will be in default. It is also unclear how receptive banks will be to refinancing Macy's loans (several which come due next year) in view of their dependence on goodwill assets to shore up their balance sheet.

Macy's CEO Terry Lundgren hopes to cover $950 million of debt that comes up next year with cash from earnings. Those future earnings will likely fall short of last year's. Much of those future earnings are already spoken for: $223 million in dividends, $560 million in bank interest, $150 million in pension commitments, and capex (Macy's wants to reduce but they will be quite significant). Free cash just is not going to do it. That leaves going into its revolving short term borrowing facility (which doesn't solve the problem, only prolongs and adds to it), selling stock (that they bought at far higher prices), and selling stores (not a lot of market there for this and automatically reduces that goodwill necessary cushion). Nothing appetizing.

Macy's looks dismal. Look for breaking loan covenants when Macy's is forced to mark down their goodwill and having trouble handling their debt in a tough retail environment.

Disclosure: Author holds a short position in M

Comments

[Ranjit Thomas:]

With reference to the last but one paragraph, earnings are after interest, pension expense and depreciation (which equates to capex). So it makes no sense to take earnings and then decrease it by these items to arrive at cash flow. In the last 12 months, M has generated $1.3Bn of free cash flow i.e. after paying interest and spending on capex. So the equity is trading at less than 3x FCF. It looks like there's enough margin even if the business deteriorates.

2008 Dec 05 08:28 AM

[Tom Armistead:]

Thanks for the information and analysis - I have a small long position in M and I have been curious as to why it was performing so poorly. Based on this article I need to take another look at M.

2008 Dec 05 09:59 AM

[notsosmart:]

R I P gimbels.dont worry macy's coming.

2008 Dec 05 09:15 PM

[Miket61:]

Macy's goodwill is not only impaired from an accounting perspective, but its goodwill with consumers is impaired in cities where they took over May Company stores. They changed the name, the management, the merchandise, and the sales staff, all for the worse. Marshall Field's would have been much more valuable if it were left as a separate division, instead of being downgraded to a Macy's. Once a major tourist draw for the Chicago area, now it's the same stuff one can buy anywhere in the country, just in a nicer building.

2008 Dec 09 11:46 PM

[Tom Armistead:]

Today Macy's announced that they were able to get the offending covenants modified. The stock is rallying on the news.

Anecdotally Macy's is not stocking as good merchandise as Filene's and several shoppers I know are disappointed.

Maybe this covenant-lite rally is a good exit point.

2008 Dec 17 02:11 PM

[taojaxx:]

Nice article that shows how a well thought out position based on sound research can be made unprofitable by a black swan:

Under the Amended Credit Agreement, the Company will be required to maintain (1) a ratio of consolidated EBITDA to consolidated net interest expense of no less than 3.00 to 1.00 through October 30, 2010 and 3.25 to 1.00 thereafter, and (2) a ratio of consolidated indebtedness to consolidated EBITDA of no more than 4.90 to 1.00 through October 31, 2009, 4.75 to 1.00 from November 1, 2009 to October 30, 2010 and 4.50 to 1.00 thereafter, all as calculated in accordance with the provisions of the Amended Credit Agreement. These requirements will replace the requirements in the Credit Agreement that currently require the Company to maintain a ratio of consolidated EBITDA to consolidated net interest expense of no less than 3.25 to 1.00 and a ratio of consolidated net debt to the sum of consolidated net debt plus consolidated net worth of no more than 0.62 to 1.00.
Stock's up 85% in a month, plus the short position was debited of the dividend...

2008 Dec 20 08:48 AM