Macy's Expecting Continued Pressure In 2016

| About: Macy's Inc. (M)
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Summary

Top line growth is a key focus at Macy's. The management team is aligned to fuel organic expansion as customer shopping patterns evolve.

We think Macy's has been able to differentiate itself from peers, albeit modestly. 2015 broke a six-year streak of double-digit 'adjusted' earnings per share growth, however.

The company recently authorized a $1.5 billion increase in its share repurchase program and a 5% increase in its dividend. We're not convinced of the firm's dividend safety.

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.

By The Valuentum Team

Macy's Investment Considerations

Investment Highlights

  • The Macy's (NYSE:M) brand operates ~870 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.
  • Top line growth is a key focus at the company. The management team is aligned to fuel organic expansion as customer shopping patterns evolve. Core business initiatives include My Macy's localization, Omnichannel 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.
  • In fiscal 2016, Macy's expects comparable sales on an owned plus licensed basis to decline by approximately 1%, and total sales are anticipated to fall by ~2% in the year due in part to 40 stores being closed in fiscal 2015. Earnings per diluted share are expected to be in the range of $3.80-$3.90.
  • Comparable-store sales have been pressured in recent quarters, but the company has high hopes for the recent acquisition of fast-growing, luxury beauty products and spa service retailer Bluemercury.
  • 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. Balance sheet strength is important in such a competitive and cyclical industry, and we're not fans of Macy's net debt position of over $6.5 billion.

Business Quality

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 18.9%, which is above the estimate of its cost of capital of 8.6%. 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.

Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Macy's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 0.7 (anything above 1 is considered strong).

Cash Flow Analysis

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 6.5% 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 increased about 20% from levels registered two years ago, while capital expenditures expanded about 10% over the same time period.

In fiscal 2015, Macy's reported cash flow from operations of ~$2 billion and capital expenditures of ~$800 million, resulting in free cash flow of ~$1.2 billion, representing a ~38% decrease from fiscal 2014.

Valuation Analysis

This is the most important portion of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate for shares.

We think Macy's is worth $52 per share with a fair value range of $42-$62. Shares are currently trading at ~$41 per share, just below the lower bound of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time.

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 -0.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 2.1%. Our model reflects a 5-year projected average operating margin of 9.1%, which is below Macy'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 an 8.6% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

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 $52 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.

In the graph above, we show this probable range of fair values for Macy's. We think the firm is attractive below $42 per share (the green line), but quite expensive above $62 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

We estimate Macy's fair value at this point in time to be about $52 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 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 $65 per share in Year 3 represents our existing fair value per share of $52 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.

Wrapping Things Up

Top line growth will continue to be a focus for Macy's. Core business initiatives include My Macy's localization, Omni-channel integration, and Magic Selling (the acronym M.O.M.). Macy's recently approved an increase in share repurchase authorization of $1.5 billion, making the total amount authorized ~$2 billion. Since resuming its share repurchase program in August of 2011, Macy's has bought back ~$7.3 billion worth of shares. Macy's has also authorized a 5% increase for its dividend to be paid in July. We like the shareholder-friendliness of management, and with shares being undervalued in our opinion, repurchases are a reasonable capital allocation option at this time.

In fiscal 2016, Macy's expects comparable sales on an owned plus licensed basis to decline by approximately 1%, and total sales are anticipated to fall by ~2% in the year due in part to 40 stores being closed in fiscal 2015. Earnings per diluted share are expected to be in the range of $3.80-$3.90 for the year. While Macy's is currently undervalued based on our fair value range, we would like to see improvements in the firm's momentum indicators and relative valuation before considering a position in the company. The firm currently registers a 5 on the Valuentum Buying Index, but we think it is certainly one for the watch list.

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.