Macy's: Appealing In The Mid-$30s Despite Secular Challenges

| About: Macy's Inc. (M)

Summary

Enthusiasm surrounding Macy's Q4 outlook and real estate monetization plans has faded quickly.

The risk-reward remains attractive in the mid-$30, based on increased willingness to monetize real estate and close underperforming stores.

With real estate providing a margin of safety to the valuation, continued buybacks, store closures, and a healthy dividend provide appeal despite the secular challenges.

The story for Macy's (M) has long been about the struggles for the department retailer, challenges felt by the wider sector and the potential monetization of the real estate. When Starboard estimated that Macy's real estate could be worth $21 billion in the summer of 2015, shares rose to the $70s. Roughly eighteen months later, shares have been cut in half, despite Macy's willingness to start monetizing part of its real estate holdings.

The reason for the drop are continued challenges in the actual business, as management has actually opened up a bit to the idea to monetize some of the real estate holdings. Shares hit a bottom of $30 this summer, only to rebound to $45 in recent weeks as investors were upbeat about comments regarding the important fourth quarter. Worries about poor holiday sales sent shares right back towards the mid-$30s, creating a buying opportunity in my eyes.

Revisiting Recent Events, Trying To Monetize Some Real Estate

Shares hit a high of $45 in recent weeks on the back of some positive news flow earlier in November. The company announced that it has formed an alliance with Brookfield Asset Management in order to increase the value of part of its real estate portfolio. The asset manger will create a plan for 50 real estate assets in the coming 2 years, as Macy has the potential to add more assets into the alliance. While this sounds encouraging, the number is relatively small in relation to the 880 stores being operated.

Important to realize is that the deal does not include the 100 stores which the company plans to close. Main reason for closing these often smaller stores are losses reported by those individual stores, or the fact that more value can be created by monetizing the real estate of those location. The 100 store number looks sizable, as Macy's has already closed 41 stores since the end of 2015, while it is exploring options for its flagship stores as well.

Sales Momentum?

Macy's reported a 4.2% fall in third quarter sales, coming in at $5.63 billion. Part of the fall is the result of store closures, as "owned" comparable sales fell by 3.3%, marking a very modest improvement from the minus 3.5% number reported for the first nine months of the year. High profile CEO Terry Lundgren was pleased with the results and is confident for the fourth quarter, driven by improvements in apparel and tech.

So-called "owned" comparable sales for the year are seen down by 2.5-3.0%. That shows that the business is expected to see some momentum if the guidance becomes a reality. Given that a third of annual sales are generated in the holiday quarter, the guidance essentially calls for a decline in fourth quarter comparable sales of minus -0.5% to -2.0%.

While comparable sales are improving from recent trends and the previous guidance, Macy's is not changing its earnings guidance. Adjusted earnings are still seen anywhere between $3.15 and $3.40 per share, for non-demanding valuation multiples given that shares trade at $36 per share. These earnings are impacted by some one-time charges, as GAAP earnings came in at seventy cents lower than the adjusted earnings number in the first three quarters of the year, mainly on the back of impairment charges.

How Is Real Estate Going, And How Does The Balance Sheet Look Like?

Alongside the third quarter earnings release, Macy's announced that it has sold $800 million worth of real estate so far. It has reached an agreement to sell its 248,000 square foot Union Square building in San Francisco for $250 million. This deal once more highlights how unreliable the balance sheet valuation of some of the real estate is, as the company recorded a $235 million gain on the sale, implying that it was valued at just $15 million on the books.

Similar options are considered for downtown Minneapolis, State Street in Chicago, and Herald Square in New York. The potential is huge in my eyes. Herald Square measures nearly 2.18 million square foot, State Street 2.05 million square foot and downtown Minneapolis 1.28 million foot.

As the Union Square building got sold for $1,000 per square foot, we have a rough estimate for the multiples we can apply to the remaining three flagship stores. While the real estate in NY will probably be more valuable, it is fair to apply a discount to the Minneapolis store. If we apply a $1,000 multiple to all of the three remaining flagship stores (which are much bigger), the value of these stores could come in at $5.5 billion.

That estimate might even be conservative, as an article of the Wall Street Journal pegged the value of the Herald Square building at anywhere between $3 and +$4 billion alone!

The company ended the third quarter with $7.1 billion in real estate value on the balance sheet, while the value of 3 flagship stores alone might already surpass $5 billion, with the book value of these three stores probably running at just hundreds of millions. As such it is fair to say that the real value of the real estate more than covers the $7.4 billion in debt, with Macy's holding half a billion in cash as well.

Value - Real Estate & Profitability

The $7.1 billion reported real estate value (on the balance sheet) is vastly understated. The $21 billion number reported by Starboard looks ambitious, as so far roughly a billion has been monetized.

If a $5.5 billion valuation for the three flagship stores is realistic, and the book value of these assets probably amounts to just half a billion orso, the realistic value of the real estate is anywhere between $12 billion (book value + excess value of the flagship stores) and a $20 billion number pegged by Starboard (corrected for recent sales). The final outcome depends on the fair value of the real estate in smaller cities, hard to measure for an outsider like me.

As such I see fair market value of the real estate anywhere between $12 and $20 billion. If the company were to divest the real estate and receive proceeds of $12 to $20 billion in a tax-efficient manner, it would have to pay market rents on these stores. Assuming a 5% rental yield, it would result in additional rent expenses of $600 million to a billion. On the flip side, these proceeds would allow Macy's to pay off all of its $7.5 billion in debt, allowing it to forego $350 million in annual interest expenses.

That leaves Macy's with a $4.5 billion to $12.5 billion net cash infusion, after netting out the net proceeds from selling real estate and paying off all the debt. Operating expenses would go up by $250-$650 million a year, being the net impact of additional rent expenses versus foregone interest costs.

The net cash infusion amounts to $15-$40 per share, assuming 305 million shares outstanding, covering a substantial amount of the current valuation per share. Yet investors will furthermore be the owner of an unleveraged retail business, which will face margin pressure as a result of being subject to market rents.

Macy's guides for adjusted operating earnings of $3.15-$3.40 per share for this year, equivalent to roughly a billion. If we factor in that operating expenses go up by $250-$650 million a year, and apply a 35% tax rate, earnings are seen at $580-$840 million a year, equivalent to $1.90-$2.75 per share. With modest multiples, this business could be valued at $20-$30 per share.

Concluding - Worth Owning

Now comes the interesting part, as the situation has a "built-in" hedge. If real estate is valued at $20 billion indeed, than investors will see a bigger cash infusion, yet the profitability of the remaining retail operation will come down as effective rents increase. As such a $40 per share monetization value based on a $20 billion valuation of the real estate will go hand in hand with $1.90 per share earnings power for the retail business, for a $60 valuation.

Alternatively. If real estate is "only" worth $12 billion and results in a $15 per share cash component, the earnings power of the retail business comes in at $2.75 per share, for a near $30 valuation. In that case the overall valuation per share could be pegged at $45 dollar. Given this range, the current price in the mid-$30s looks relatively attractive.

In the meantime the company continues to operate relatively prudently with regards to leverage, as debt is offset by real estate (book value) and cash holdings. By closing underperforming stores, and thereby maintain profitability, investors get paid to wait with a 4% dividend yield, accompanied by modest share buybacks.

I do not mind buybacks as I regard these levels in the shares as relatively low, despite the secular challenges faced by the business of course. As a result, I am a buyer at current levels, with a exit target of $45-$50 per share.

Risks to the thesis include of course further deterioration of the physical brick-and-mortar store model, and poor realizations or unwillingness to monetize real estate. That said, management seems to have turned a corner on the real estate debate as the outlook for the holiday quarter looks encouraging.

If the company manages the transaction well to close underperforming stores, use capital wisely in terms of deployment, monetize real estate and continues to run the business well, better days might be ahead amidst a favorable risk-reward set-up.

Disclosure: I am/we are long M.

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.

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