"Fashions fade, style is eternal" is the famous phrase coined by Yves Saint Lauren. Fashion will never run out because as one fades another one takes its place. People are drawn to the good things in life. For some, it is a choice while for others it is a necessity. Sometimes owning fashionable apparel makes one look more acceptable to the status quo. One company that makes people feel good about owning luxury apparel is the luxury department store chain Macy's Inc. (M).
Macy's is an omni-channel retail organization that operates brick and mortar stores as well as ecommerce websites under two brands: Macy's and Bloomindales. The company sells a wide range of apparel and accessories for men, women and children as well as home furnishing products, cosmetics and other goods. The company has 840 department stores and 13 Bloomingdale's outlets.
Macy's business generated a higher return in the second half of the fiscal year because of the seasonal nature of the business. A company's margins are better in the second half of the fiscal year than the first half of the year because of the Christmas season.
A slight decline in gross and operating margins can be seen in the most recent quarter of the current fiscal year when compared with the results of the corresponding period of 2012. However, Macy's net margin is slightly higher this year than the same quarter of the previous year.
The company's revenue and cost of revenue experienced a decline in the second quarter of fiscal year 2012. However, the decrease in the cost of revenue was lower than the decrease in revenue. This caused a lower gross margin in the latest quarter of the current fiscal year.
In Q2 of FY 13 operating expenses decreased by 0.50% but these expenses increased as a percentage of revenue from 32.84% to 32.95% YoY. This resulted in the company reporting a lower operating margin. Despite reporting a lower gross margin and lower operating margin, the company reported a higher net margin in the second quarter of the current fiscal year compared to the second quarter of fiscal year 2012. The higher net margin is attributed to lower interest expenses and a lower effective tax rate in the most recent quarter of the current fiscal year.
Recently, Macy's has outperformed the industry. Macy's revenue grew by a faster pace than the industry average. The company's revenue grew with a CAGR of 5.60% over the last three years compared to the industry's CAGR of 1.50%. The company's net income grew by a CAGR of 59.50% over the last three years compared with the industry's CAGR of 20.20%.
As shown in the following graph, the company's net margin, operating margin, ROA and ROE are well above the industry average. It is important to note that the company's ROE is 23.40% which is much higher than the industry's average of 1.90%. The high ROE is mainly attributed to a higher net margin and the company's higher assets turnover. Although, the company's financial leverage is slightly higher than the industry average it is not contributing much in higher ROE of the industry.
Per capita disposable income is a key metric in measuring an individual's ability to purchase goods and services. According to recent research report published in September 2013, per capita disposable income declined to $32,897 from $33,229 over the last five years with a CAGR of -0.20%. According to the report, per capita disposable income is expected to grow to the record level of $37,249 with a CAGR of 2.50% over the next five years. Therefore, I believe that the company's performance over the next five years will be better than its performance in the last five years.
The current economic condition of the United States has not yet recovered but research shows that the United States will eventually overcome this crisis. Moreover, per capita income has a low level of volatility. It is important to note that this measure only includes income available for spending after taxes and savings. This characteristic has allowed for American spending to stabilize over the long run. Moreover, saving accounts and alternative income streams (i.e. unemployment fund) help individuals to maintain their spending lifestyle. These factors will support the company and help it to report decent results in the long term.
Macy's has managed to consistently report healthy results despite the challenging economic conditions and cautious consumer spending. Healthy results in a challenging environment are mainly attributed to the company's omni-channel strategy. Recent consumer spending reports show that per capita disposable income will not experience a decline owing to savings accounts and other sources of income. Therefore, I believe that the company will be able to report higher margins due to stable per capita disposable income and its omni-channel strategy.
The company has a rich history of dividends. By paying dividends the company is sharing its success with investors. Therefore, in order to compute the fair value of the stock I have used the dividend discount model.
(click to enlarge)The average modified payout ratio of the stock over the last five years is 67.61%. Analysts estimate a growth rate of 12.32% for the next five years while the company's sustainable growth rate is 22.46%. The historical growth rate of the company is 12.19%. I have assigned different weights to these growth rates and calculated a growth rate of 14.84% for the company.
(click to enlarge)As shown in the following table, the company's cost of equity is calculated using a beta of 1.33. The risk free rate on a 10 year Treasury bond yield is 2.68% and the market return is 8.30%. Using a 10.17% cost of equity as the discount rate the fair value of the stock equals $51.75 which gives an upside potential of 19.77%.
Moreover, in order to compute the low and high target prices I have conducted a sensitivity analysis. In the dividend discount model, the fair value of the stock is affected by cost of equity and expected growth rate. Therefore, I have used these two key components of the DDM model in order to determine the fair value of the stock. As shown in the following table, the stock has an upside potential of 33.36%. In the worst-case scenario, where I have assumed that with a cost of equity of 10.52% and an expected growth rate of 14.24%the intrinsic value of the stock equals $47.45.This is still higher than the current market price of the stock.
Although the company did not report margins higher than the net margin in the second quarter of the current year fiscal its performance was much better than industry results.
The increase in per capita disposable income will help the company to post improved margins in the future. Moreover, past results show that the company has performed better than the industry even during economic crisis because of its omni-channel business strategy.
Using the DDM I have calculated the company's fair value of the stock and it equals a capital return of 19.77% with an upside potential of 33.36%. Moreover, the company's target price in the worst case scenario is $47.45 which is 9.82% higher than the current price. Therefore, I would recommend buying the stock.