Macy's: A Deep Value Trap?

Investment Thesis

Although Macy's () was established in 1985, the company has a long history of operating department stores dating back to 1820. Today, they run 722 stores in the US under various brands including Macy's and Bloomingdale's. They offer a diverse range of products such as clothing, cosmetics, home furnishings, and more. However, things haven't been so good the past few years.

Currently, the stock is down more than 40% year-to-date after the company reduced its guidance and increased its capex spending to pursue growth opportunities. The stock now seems to be in deep value territory, especially when we take into account the value of their real estate portfolio. Nonetheless, we believe this appears to be more of a value trap than a market misjudgment. There are no catalysts in place to capitalize on the value of the real estate, and the retail business is facing several headwinds, which will likely keep the stock under pressure for the foreseeable future.

Current Financial Situation

Last year, Macy's reported net sales of $24.44 billion, which represented a 0.3% increase in comparable sales YoY, and net credit card revenues of $863 million, up 4.3% YoY. However, due to inflation pressures, the cost of sales and G&A expenses outgrew revenue growth, causing the operating margin to decrease from 9.6% to 7.1%. Net income was $1.17 billion, and free cash flow was $727 million.

However, this year the situation worsened. In the first half of the year, net sales and credit card revenue dropped 8.3% YoY, while the operating margin decreased from 7.6% to 3.5%. Furthermore, net income was $131 million, compared to $561 million in H1 2022, and free cash flow was negative. Not only did their profitability drop, but they also increased their spending on capex.

Management expects to spend $950 million on capex this year and about $2 billion more over the next two years (slide 9), focusing on digital and technology investments, data and analytics, supply chain modernization, and omnichannel capabilities. We estimate that maintenance capex is around $600 million, so they are spending an extra $300-$400 million a year to fuel growth. Is this a smart capital allocation decision? In our view, it's not. With $300 million in free cash flow, they could buy back 10% of the outstanding shares per year. Instead, they are "investing in growth and tech", which is yielding no results whatsoever.

At $11.60, Macy's has a market capitalization of $3.20 billion. If we sum financial debt ($3 billion) and subtract cash and equivalents ($440 million), we arrive at an enterprise value of $5.76 billion. When compared to its closest peers (Kohl's (NYSE:KSS) and Nordstrom (NYSE:JWN)), we note that Macy's is trading at a discount on an EV/EBITDA (forward) basis. We believe that this discount is related to the poor capital allocation decisions made by the management. Furthermore, the company revised its full-year revenue guidance from $23.95 billion at the midpoint in March to $23 billion at the end of June, which is a billion less. Adjusted EPS is now expected to be $2.95 at the midpoint versus $3.89 before.

Although the current situation is not great, we believe that in a normal year, Macy's could generate approximately $1 billion in free cash flow. Applying a multiple of 8x-10x to that figure puts the stock at around $22 per share, representing a potential 100% increase from its current level. Additionally, the stock pays a $0.66 dividend, which translates to a 5.7% yield at current prices, and they have been regularly buying back stock in recent years.

But What About The Real Estate?

When valuing Macy's, looking only at the free cash flow the business can generate would be a mistake. The company holds a very valuable amount of land and properties on its balance sheet. This is no secret, as there have been several activist investors who have tried to take action and make the board spin off or sell these assets during the past years. Since 2013, Macy's has realized $1.92 billion in gains from the sale of real estate, but the pace of sales has been decreasing in recent years. And given the state of the current real estate market, I would not expect to see a pickup now.

Net PP&E on the balance sheet is $5.5 billion, but many analysts estimate that the real market value is closer to ~$10 billion. If we just assume $5.5 billion to be conservative, this translates to ~$20 of value per share. Basically, in a SOTP valuation, Macy's stock could be worth +$40 per share.

Risks

The SOTP valuation is very compelling but it would be a mistake to assume that the market would re-rate the stock to that price. As we mentioned, many activist investors tried and failed in the past. The only way to realize the value of the real estate is to do a spin-off or a sale of the assets, for which there are no plans in sight. Otherwise, the stock will always look cheap on a SOTP basis.

On another note, the retail business has been under pressure this year due to several rate increases, inflation, and the deterioration of consumer spending. Moreover, Macy's has seen an increase in credit card delinquencies during the past quarters that are also affecting margins. With a recession around the corner, Macy's would be severely affected by it. If financials deteriorate, the company may start burning cash rapidly, which would change the whole equation of its valuation.

Conclusion

In conclusion, Macy's drop has put the stock in deep value territory. However, we don't see any clear catalysts that can propel the stock higher in the short to medium term. As such, we think that it is best to keep your position small or wait for things to clear up before buying into the stock.