Macy's Dividend Safety Discounted

| About: Macy's Inc. (M)

Summary

Macy’s uses its strong brand to differentiate itself from peers in the highly-competitive retailing industry.

Weakness in the retail sector continues to pressure Macy's free cash flow generation, and we're not particularly fond of the lack of cushion found on the firm's balance sheet.

Though Macy's dividend yield remains compelling, our opinion of the safety of its payout has soured materially since early 2015.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Macy's (NYSE:M) uses its strong brand to differentiate itself from peers in the highly-competitive retailing industry. Historically, the firm has used this distinguishability to drive material growth since the depths of the Great Recession as it took advantage of the improving plight of the US consumer. Since 2009, EBITDA margins have grown nearly 3 percentage points, and ROIC has improved materially. In 2015, the firm shifted its focus to top-line growth, though it has had trouble delivering on its initiatives. Comparable-store sales have been pressured in recent quarters, but the company has high hopes for its acquisition of fast-growing, luxury beauty product and spa service retailer Bluemercury. Store closings can be expected.

In such a competitive and cyclical industry such as the multiline retail industry, balance sheet strength is a material advantage, which Macy's lacks as it has a net debt position of more than $6.6 billion as of July 2016. Though the firm's free cash flow generation has typically been sufficient to handle debt service costs while paying a dependable dividend, the recent weakness in the retail sector, which is out of the control of Macy's, has impacted its free cash flow generation, which fell to ~$1.2 billion in fiscal 2015 from ~$1.9 billion in both fiscal 2013 and 2014. Share repurchases have eaten up a significant amount of capital in recent years, increasing to just over $2 billion in fiscal 2015 from ~$1.6 billion in fiscal 2013.

The confluence of the above factors has caused Macy's dividend strength to wane as of late. The firm's Dividend Cushion ratio has fallen to a paltry 0.3 as of the most recent update from healthy levels well above parity as recently as early 2015. Its yield remains compelling at ~4%, but we feel there are far better income generation ideas available on the market. Let's tear into the rest of the company's investment highlights as there is far more to consider than a stock's dividend!

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Image source: Valuentum

Macy's Investment Considerations

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Investment Highlights

• The Macy's brand operates ~850 Macy's department stores and furniture galleries, as well as macys.com. The Bloomingdale's brand includes ~40 department stores and home stores, bloomingdales.com, a number of Bloomingdale's Outlet stores and a licensed store in Dubai. The company was founded in 1830 and is headquartered in Ohio.

• Full-line store closings will be a key initiative in the near term as the firm plans to close 100 such stores to pursue opportunities to create value with its real estate portfolio. Core business initiatives include My Macy's localization, Ominichannel integration, and Magic Selling (the acronym M.O.M.).

• We think Macy's has been able to differentiate itself from peers, albeit modestly. Consumers associate Macy's with the Thanksgiving Day Parade, Fourth of July Fireworks, flower shows, fashion extravaganzas, celebrity appearances, and holiday traditions. 2015 broke a six-year streak of double-digit 'adjusted' earnings-per-share growth.

• Still, the retailing industry is intensely competitive. Macy's competes with many retailing formats, including department stores, specialty stores, discount stores, manufacturers' outlets, the Internet, mail order catalogs and television shopping, among others.

• In fiscal 2016, Macy's expects comparable sales on an owned plus licensed basis to decline by 3%-4%, and total sales will be impacted by ongoing store closings in the year. Earnings per diluted share are expected to be in a range of $3.15-$3.40.

Business Quality

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Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Macy's 3-year historical return on invested capital (without goodwill) is 19.5%, which is above the estimate of its cost of capital of 8.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

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Image source: Valuentum

Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Macy's free cash flow margin has averaged about 6.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Macy's, cash flow from operations decreased about 22% from levels registered two years ago, while capital expenditures expanded about 28% over the same time period.

Valuation Analysis

We think Macy's is worth $48 per share with a fair value range of $38-$58.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of -0.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of -0.7%.

Our model reflects a 5-year projected average operating margin of 8.9%, which is below Macy's's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.6% for the next 15 years and 3% in perpetuity. For Macy's, we use a 8.9% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

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Image source: Valuentum

Margin of Safety Analysis

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $48 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Macy's. We think the firm is attractive below $38 per share (the green line), but quite expensive above $58 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

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We estimate Macy's's fair value at this point in time to be about $48 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Macy's's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $59 per share in Year 3 represents our existing fair value per share of $48 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.