Is Macy's 7% Dividend Too Good To Be True?

Summary

• Macy's is a brand name synonymous with American retail; it's hard to imagine a future without Macy's, but I fear we may be heading in that direction.
• Due to recent weakness in the face of e-commerce related headwinds, Macy's stock has sold off to the point that the company is yielding 7%.
• This massive yield looks great at first, but not so much after you look at the company's post-great recession dividend cut and analyst estimates for future EPS.
• If I felt comfortable that this dividend was safe, I would buy shares today at $21/share.  However, I fear that this dividend is likely to be cut.

I’ve made it no secret that I’m a bear on the retail industry. I’ve been in this boat for awhile now. I’ve taken steps over the last 2 years to sell off all of my retail names, except for Amazon (AMZN), which is the disruptor that is causing all of the problems for traditional retail in the first place, and some Kroger (KR) shares that I consider to be "house money" after a very successful trade a few years back. I’ve even gone as far as to say that retail/apparel names are simply un-investable in the present due to this disruption. But, even with that being said, I’d be lying if I said that Macy’s (NYSE:M) dividend yield rising above the 7% threshold didn’t catch my attention. In this piece I’ll be taking a look at this dividend, as well as Macy’s valuation, to see if this stock is worth a deep value flier, or if this will continue to be a value trap with a sucker’s yield.

With the market hovering near all-time highs and valuations generally high across the board, I find that I’m forced to look at out of favor industries for stocks with cheap valuations. This is why I continue to track the retail space, even though I’m not particularly bullish on the long-term prospects of many of the traditional brick-and-mortar players in the space. I know that there will eventually become a time when the value investor in me gets the best of my personal sentiment regarding retail. Back In January, I wrote this piece focused on Macy’s titled, “Is Macy’s 5% Dividend Worth The Risk?” My conclusion at the time was that it wasn’t. The stock has traded down ~25% since then. The 5% dividend wasn’t enough to entice me into the name, but what about 7%?

My focus is on the dividend when it comes to Macy’s because it’s really the only thing that potentially attracts me to the stock at the moment. Macy’s represents a potential turnaround story which could lead to considerable capital gains, but I think this will be a long, arduous process and therefore, I would need the income to tide me over in the near term as I wait to see what happens with regard to restructuring to be more competitive in the current retail environment. I have a feeling that I’m not alone here; I’m sure that many DGI investors see a great American brand name like Macy’s offering such a juicy yield and their eyes light up. But since growth is unlikely in the short term, M remains an income play, at best, until it becomes clear that it isn’t headed the way of the dodo.

But, the company’s 7% yield means nothing if it is not sustainable. If I were to buy Macy’s I would only do so if I felt confident that the current payment would remain intact while I waited for the turnaround to take place. At this point, I think dividend growth is out of the question. Any excess funds that Macy’s has should either be dedicated towards growing its digital channel and/or buying back shares at these rock bottom valuations. Frankly put, the company should probably cut its dividend and focus on these two things anyway. I’m sure management realizes that cutting the dividend would likely do significant damage to the share price, but that may not be its biggest concern as the long-term future of the company comes into question. With all of this in mind, it’s going to be very hard to convince me that an investment in Macy’s in the present is worthwhile. However, I’m still willing to take a look because if there is any chance that this company can stabilize sales/earnings, it has massive potential as a deep value turnaround play.

Even though Macy’s has a brand name to die for, it is not a dividend aristocrat. Macy’s cut its dividend in 2010 after a couple of lean years coming out of the great recession. The fact that Macy’s dividend increase streak is so short leads me to believe that it is more likely to be cut by present management. No one wants to be the guy or gal at the helm when a 50-year dividend increase streak is ended, but I don’t think anyone’s legacy would be tarnished by cutting a streak that is only 6 years old.

Source: F.A.S.T. Graphs

In 2007, Macy’s dividend was $0.51/share and EPS was $2.36. At the time, I’m sure investors looked at this and said, “that’s a well covered dividend.” And it was… for the time being.

In 2008, Macy’s dividend was $0.52/share and EPS was $2.15. In 2008, the dividend rose 2% while the earnings decreased by 9%. This wasn’t a sustainable long-term trend; however, the payout ratio was still a very conservative 24%, so things still appeared to be rosy…right?

Well, in 2009, Macy’s dividend was $0.53 and EPS was $1.26. In 2009, the dividend rose another 2%; however, this time EPS crashed, falling 41% y/y. Because of this 41% crash, M management decided to cut its dividend, which came in at only $0.20/share the following year, representing a 62% slash.

Sure, the EPS recovered a bit in 2010 and then bounced back to previous levels during a grand year in 2011 for Macy’s, but management couldn’t know that this would happen when it slashed the dividend. No one, including management teams, has a crystal ball. They have to make the best decision that they can with all of the information available at hand.

When the dividend was cut after a terrible 2009, the payout ratio was still a rather conservative 37%. The payout ratio using recently reported FY17 earnings is already above that threshold, at 48%. Right now, the consensus analyst estimate for FY18 represents a bit of growth for Macy’s at $3.34 versus the $3.11 it posted in 2017; however, looking out to 2019, the average analyst estimate is only $2.78. It’s worth noting that these are non-GAAP figures, if you’re a fan of using GAAP metrics, these EPS numbers come in much, much lower. My point here is that the current payout ratio is actually higher than it was when M last cut its dividend, meaning that the 7% yield that the company currently pays may not be safe. If analysts are correct (or remotely close to being correct) with regard to the 2019 EPS coming in below $3/share (which would likely represent something like $1.70 on a GAAP basis), then the current $1.51 dividend would appear to be in big trouble.

Looking at this F.A.S.T. Graph, we see that if Macy’s is able to continue to pay the current dividend for the next couple of years, it wouldn’t take much in terms of multiple expansion for a buyer of the stock today to make a respectable annualized return over the next couple of years. If this dividend goes away, a big portion of these returns do as well, however (I also think it’s safe to assume that if the dividend is slashed, even if it’s the most prudent decision for management to make, the share price will follow suit, in the short term, at least).

Source: F.A.S.T. Graphs

It will be interesting to see what M’s management does with regard to the dividend moving forward. As I said before, due to the current valuation (Macy’s is trading for just 11.4x ttm GAAP EPS and 0.2x sales) it seems obvious to me that management should buy back as many shares as it can. If the company is able to stabilize things and return to some semblance of growth in the next couple of years (and that’s a big if, at this point), M should be able to generate nice returns on shares retired at these levels.

This 0.2x sales figures really stand out to me. This essentially means that the market is placing zero value on the business operations in the present, expecting negative growth moving forward into the foreseeable future. When you factor in this, and then add in the company’s real estate value as a bit of a kicker, it seems crazy that M’s market cap has fallen to just $6.45b.

Although Starboard has exited its position in Macy’s it wasn’t all that long ago that the firm thought that M shares were cheap because the company’s real estate assets were worth in excess of $21b. Starboard released this report in January of 2016 claiming such. Here’s an image from the report, breaking down Macy’s real estate assets. It’s worth noting that this report is 18 months old and since then Macy’s has sold some assets and I’m sure the real estate value has fluctuated, meaning that these numbers are likely no longer accurate. But, I don’t think that things have changed enough to make this report meaningless.

Source: Starboard Macy's Presentation

Now, even though the activist firm has thrown in the towel on Macy’s, it’s hard to imagine that Starboard was that far off in its real estate valuation estimate. As previously stated, M’s market cap currently sits at ~$6.5b; I wouldn’t be surprised if the crown jewel of Macy’s real estate portfolio, the iconic Herald Square store in New York, is worth at least 1/3 of the total market cap at this point. Even if Macy’s didn’t sell the building outright, I think it could generate massive cash flows renting out the space. This isn’t the first time that I’ve brought up the value of real estate when talking about a potential investment in Macy’s. The Macy’s real estate/REIT argument has been made by me, and others, numerous times since the stock was trading at $40/share in early 2016. It made sense then as it continues to make sense now, but that didn’t prohibit long-term investors from taking massive losses on the shares that have traded down from $65 in mid-2015 to $21 today.

With that said, the real estate value doesn’t solve many of the company’s problems regarding declining sales and struggling stores. Sure, if the company sells properties it adds money to the balance sheet, but it is also a one-time deal and doesn’t do much to generate cash flows over the long term. Another bit of recent news that tarnishes another bright spot for Macy’s was the Wall Street Journal report released yesterday focused on strong discounting that are popping up in the cosmetic space. Cosmetics have long been a stronghold within the department store space with regard to premium pricing and high margins. I highlighted the fact that Macy’s was attempting to make headway in this space with its Blue Mercury stores in my previous Macy’s article. I liked the investments that the company was making into Blue Mercury; it was hard to argue with the results that Ulta Beauty (ULTA) was producing in the cosmetics space, seemingly acting as one of, if not the only, truly, Amazon-proof retail concept. But even after continuing to post fabulous results, chinks have appeared in ULTA’s armor in recent months, with the stock trading down nearly 20% from recent 52-week highs. If this discounting persists, then it makes Macy’s investments in Blue Mercury less valuable/productive, in my opinion. If anything, I think this just goes to show that nothing is truly safe from Amazon’s influence.

So, what’s an investor interested in the retail space to do? This industry is certainly a tricky place to invest right now. You’re either forced to pay sky-high valuations for the stocks like Amazon (186x earnings) or Ulta Beauty (35x earnings) that are working or take chances with potential value traps like Macy’s, Target (TGT), or Kroger, all of which have near single-digit valuations, but also don’t seem to have many growth prospects in the near term. This is why I’ve chosen to essentially stay away (with the exception of AMZN, which I believe to be a ‘must own’ type stock for a younger investor). The market is a big place and there are many fish in the sea. Right now, I’m interested in Macy’s high yield, but my fears concerning the dividend’s sustainability still persist. Because of these fears, I will likely stay out of the name. I realize that by being cautious here I am potentially missing out on a major turnaround play, but I don’t like investing in areas of the market where secular headwinds are strong.

What do you think? Will this weakness prove to be a buying opportunity over the long term or has AMZN simply done too much damage to these traditional department store names for them to recover?

Analyst’s Disclosure: I am/we are long AMZN, KR. 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.