As the economy nears full employment, one of the first beneficiaries will be retailers. I expect this time period to come just in time for the start of the school season. As an IR consultant, I see strong returns from smaller under-followed companies when press coverage improves. For example, Dussault Apparel (OTC:DUSS) is significantly undervalued.
In the meantime, the larger companies will receive a disproportionate amount of attention. In this article, I will run you through my DCF analysis on Macy's (M) and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to J.C. Penney (JCP) and Wal-Mart (WMT). I find that the company is meaningfully undervalued.
First, let's begin with an assumption about revenues. Macy's finished FY2011 with $26.4B in revenue, which represented a 5.6% gain off of the preceding years, a slight deceleration. Analysts model a 12.4% per annum growth rate over the next half decade, which seems somewhat optimistic given that it is nearly 200 bps higher than what is expected for the S&P 500.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures and taxes. I model cost of goods sold as 59.5% of revenue versus 33% for SG&A and 2.2% for capex. Taxes are estimated at 36% of adjusted EBIT (excluding non-cash depreciation charges).
We then need to subtract out net increases in working capital. I estimate that this will hover around -0.9% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 11% yields a fair value figure of $50.10, implying 26.1% upside. This is a high WACC due to the company's high volatility. But the market seems to be factoring in a WACC of 12.5%, which is much too high given the company's solid brand name and growth opportunities.
All of this falls within the context of strong performance:
"Our cash flow was also very strong throughout the year in 2011. During the year, operating activities generated $2.1 billion of cash as compared to $1.5 billion last year. Our pension contribution this year was $375 million versus $825 million a year ago. And CapEx was $764 million this year, below the budgeted $800 million, due to the timing of the cash outlay. Cash flow before financing activities was $1.476 billion, up $435 million over a year ago."
From a multiples perspective, Macy's is similarly attractive. It trades at a respective 13.6x and 10.5x past and forward earnings vs. 12x forward earnings for J.C. Penney and a respective 13.5x and 11.6x past and forward earnings for Wal-Mart. Assuming a multiple of 13.5x and a conservative $3.70, the rough intrinsic value of Macy's stock is $49.95 - roughly in-line with my DCF result.
Consensus estimates for J.C. Penney's EPS forecast that it will grow by 25.6% to $1.57 in 2013 and then by 91.7% and 37.5% in the following two years. Assuming a multiple of 13.5x and a conservative 2013 EPS of $2.95, the rough intrinsic value of the stock is $39.83, implying 12.4% upside. Management has recently undertaken a massive restructuring of the brand image. In addition to slashing prices, they are also restructuring store layout and advertising. All of this seems like a lot of desperation, as if they mean to say: "Hey, look! See what we are doing." Shoppers can be very unpredictable, so do take these efforts with a grain of salt.
According to T1 Banker, analysts are more optimistic about Wal-Mart. They expect the largest retailer to grow EPS by 28.7% from 2012 to 2015, which seems more than manageable. Wal-Mart is an attractive driver of free cash flow and thus has limited upside. Opportunities in emerging markets also skew risk asymmetry much more toward reward. Assuming a multiple of 14x and a conservative 2013 EPS of 5.21, the rough intrinsic value of the stock is $72.94, implying 19.2% upside.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.