Value Investors: Walking The Walk With Macy's
It’s easy for value investors to talk the talk, to wax poetic about low ratios, margins of safety, buying when others are fearful, and so forth. But department stores in general and Macy’s (M) in particular exemplify the challenges of walking the walk. Things in this business are bad – really, really bad – and putting money on the line here can be scary for investors who’ve long been coached to cherish upward revisions, positive surprises, industry leadership, expanding markets and so forth. But you have to pay up to get at the good stuff. If you want value, then you need to be willing to live adventurously.
The Value Quandary
It’s so easy to get lulled by the rhetoric of value into believing this is a conservative way to invest. It’s not. P.T. Barnum is reputed to have said “there’s a sucker born every minute.” But if you think they’re all in the stock market waiting to sell you great companies at bargain prices, the sucker may be you. The market can be imperfect – there are many stocks priced lower than they should be relative to company fundamentals and that happens because different investors interpret the same set of facts in different ways. But Mr. Market isn’t nearly as stupid as Graham-Buffett folklore leads many to believe. When you see a truly cheap stock, expect baggage and base your decision on whether the baggage is or is not excessive relative to the valuation. But either way, learn to love corporate baggage.
Let’s focus on Macy’s (NYSE: M) which appears in Portfolio123’s Underestimated Blue Chips portfolio.
Department Store Baggage
It doesn’t take detective work to identify the baggage afflicting Macy’s and its department store peers. It just takes observation of and participation in life. Ah, for the good old days, when people were afraid to use their credit cards to buy things on line, and when shop-till-you-drop at the mall was about lifestyle, not just necessities. Macy’s was a leader back then with its quality merchandise allocated to departments each of which had its own party atmosphere. Today, however, we buy things with the click of a mouse, or the tap of a finger. We get what we want (and don’t worry if the local store will still have it in inventory when we get there) and can price shop without even standing up, much less walking or driving.
As modernity tightened its grip on department stores, the latest quarter turned out to have been a big-time stinker. The numeric details aren’t important. What is important are the fact that they were disappointing, often worse than expectations, devoid of visible recovery stories and set in a context that suggests long-term deterioration.
Macy’s Gets It And Is Working to Cope
The company acknowledged that its customers are going digital – its latest sales report confirmed weaker-then-expected results at stores but good results on line, hardly a surprising revelation. The merchant is in the process of closing 100 stores out of 730. That’s a big percentage. The stores selected for shuttering are those in locations no longer deemed to be quality shopping destinations and those that present opportunities to monetarize valuable real estate.
But it’s not just cut, cut, cut. The company is investing in customer data and analytics to support its growing digital efforts. It also is likely to work further in the order-online-pick-up-in-store approach.
The Plan Seems Credible
It’s easy for a cynic to suggest Macy’s is simply reciting the survival rhetoric but that it’s useless to expect anything other than ultimate extinction. But cynicism, although helpful in assessing stocks, is not an end unto itself. Consider Amazon.com (AMZN) +0.43%’s ongoing efforts to open brick and mortar stores, including one in my neighborhood, at the Shops at Columbus Circle “mall” in New York City’s. It’s hard to make sense of this if brick and mortar (or steel and glass in the case on Columbus Circle) is really and truly dead (store space doesn’t come cheap at the Manhattan location selected by Amazon). And if anybody’s opinion here is worthy of credence, it’s that of Amazon.com CEO Jeff Bezos, who did so much to disrupt conventional retailing and probably forgot more about brick-and-mortar woes than most investors will ever know. And long before even this, I’d walked through (now shuttered) Barnes & Noble (BKS) locations wondering why they didn’t try to work hand in hand with their on-line operation instead of treating it as an enemy (as that bookseller did when the store discount cards I and many others used to buy regularly were not honored for purchases made via the company’s web site).
I already tried on-line order and store pick-up at Best Buy (BBY) -0.90% and thought it was great, and I started buying apparel on-line knowing how I could easily take it back to a nearby store if I had to return it and didn’t want to pack and ship. And let’s face it; for a lot of things there is something to be said for physically seeing and handling product before plunking down one’s credit card. (Pre-internet, there was a segment of retail known as Catalog Showroom.)
It’s unrealistic to expect physical shopping to vanish and have no role. It’s also unrealistic for brick-and-mortar locations to pretend they can operate without reference to on-line, as did Barnes & Noble. I can’t tell you what retail will look like in ten years. But I do believe the ingredients for success will be a respected brand (Macy’s: check!), and a sense that management gets it (Macy’s: check!), and enough financial strength to get from here to there (Macy’s: check! – see below).
Macy’s isn’t a leader in new-generation retailing (it seems a long way behind big gorilla amazon.com). But whether that’s a problem depends on whether the stock is valued under the assumption that it is a leader. In this case, it isn’t. And actually, the stock is valued under assumptions of considerable shrinkage.
The Valuation
Since Macy’s came to my attention through the Portfolio123 Underestimated Blue Chips portfolio (an investable portfolio you can track for free), I’ll use the framework of that model to assess the stock. The model assumes that P (price of a stock) is equal to V (its value) plus N (noise) and looks for low-noise stocks showing potential for an future increase in bullish noise.
I take a conservative approach to valuation, a “standstill value” approach. I divide net operating profit after tax (NOPAT) by the cost of capital appropriate to the company’s balance sheet. I assume zero profit growth. On this basis, I value Macy’s stock at about $45 per share. The stock is priced at about $30. This means that investment-community noise, which usually adds something to valuation, is operating here as a huge negative. (Typically, noise contributes about 20% to the prices of able easy-to-value blue-chip stocks; for Amazon.com, noise is about 90%.)
Bear in mind that the operating profit figure I used as a starting point to calculate the NOPAT I used in the Macy’s valuation ($1.5 billion over the trailing 12 months), is already well below that of the latest fiscal year ($2 billion), and further below the prior year’s $2.8 billion peak. The cost of capital figure I used was about 7%, well above junk bond levels today.
Here are a few other tidbits that did not factor specifically into my model but are worth noting:
- The stock’s yield is 4.9%.
- In the trailing 12 months, cash from operations ($2 billion) was more than ample to cover the dividend ($456 million) and capital spending ($637 million), as was the case in prior years.
- The company has been using surplus cash to repurchase stock since fiscal 2012 and it looks like it can afford to continue to do so.
- Relative to other department stores, the company’s inventory turnover is a bit low (2.64 versus 2.93) but its gross margin is higher (39.08% versus 35.94%), consistent with its position as a non-bargain merchant of decent quality products.
- Turnover and margin balance one another in the Return-on-Investment metric. For Macy’s, these figures were 12.32% and 8.01% for the 5-year average and trailing 12 months) versus Department Store medians of 10.85% and 7.88%. So yes, the group is sliding, but Macy’s is still in the upper half.
- Macy’s is more willing than many department stores to use debt (1.98 debt to capital versus industry median of 0.67). But Macy’s can manage it; the company’s interest coverage ratio is 4.07, close to the 4.60 median that’s associated with a much lower debt ratio.
- Returns on equity (which combine return on investment with debt leverage) have come down, which is not surprising for a department store in the trailing 12 months versus the 5-year average (17.73% versus 23.37%), but they’re still better than the medians for the Department Store group (11.32% and 17.23% respectively) and the S&P 500 (14.41% and 14.86% respectively)
Bottom line: With this much negative noise (fear) incorporated into the Macy’s stock price, this looks like an interesting value play.
Disclosure: None