M - Buy Macy's: It's A Covered Land Play In Disguise

2023-09-07 06:48:07 ET

Summary

• Macy's stock has fallen more than 50% since the beginning of 2022, including a sharp drop in August.
• Despite facing inflation-related challenges, Macy's remains profitable and deeply undervalued based on conventional valuation metrics.
• Macy's real estate is likely worth at least $10 billion, whereas its enterprise value has fallen below $6 billion.
• Macy's resembles a covered land play: it owns a collection of attractive real estate that generates some cash today and can be redeveloped for more valuable uses in the future.

Following a spectacular recovery from the initial devastation of the COVID-19 pandemic, shares of Macy's ( M ) have fallen more than 50% since the beginning of 2022. Macy's stock lost more than a quarter of its value in August alone, as the company's Q2 earnings report stoked fears of an extended downturn for the business.

Macy's does face significant challenges. Most notably, inflation is crimping customers' discretionary budgets and contributing to an increase in credit card delinquencies (not to mention driving up costs). That said, the company remains solidly profitable and continues to churn out ample cash flow, making Macy's stock look very cheap based on conventional valuation metrics.

Moreover, investors shouldn't value Macy's purely as a department store. Rather, the company resembles a covered land play: a valuable real estate asset (or in this case, a collection of valuable properties) currently occupied by a low-value use.

Buying Macy's stock for around $12 will prove to be a steal if the company succeeds in returning sales and earnings to growth in the years ahead. But even if management fails to turn the business around, investors are likely to achieve very strong returns as Macy's monetizes its real estate for redevelopment over time.

Profit under pressure

Last year, Macy's generated adjusted EPS of $4.48: down from a record $5.31 in fiscal 2021, but still very strong by historical standards. However, entering fiscal 2023, management warned investors to expect adjusted EPS to decline again due to the negative impact of inflation on discretionary spending. It projected that comp sales would fall 2%-4%, leading to adjusted EPS of $3.67-$4.11.

Sales trends deteriorated significantly beginning in late March: just weeks after management provided this initial forecast. That forced Macy's to cut its guidance in early June. It now expects comp sales to decline 6%-7.5% and adjusted EPS to fall to between $2.70 and $3.20.

While Macy's recent Q2 results beat its official guidance and the company reaffirmed its full-year forecast, management acknowledged fresh headwinds. During the quarter, delinquency rates for Macy's proprietary credit card portfolio jumped. That reduced credit card revenue , which is typically a major earnings driver for the company. Macy's also moderated its asset sale projections for the year, as high interest rates have negatively impacted demand for its excess real estate.

Still, if Macy's achieves its current full-year guidance, the results will be respectable compared to its historical performance. In early 2020 (before the COVID-19 pandemic had hit the U.S.), Macy's projected that it would post adjusted EPS between $2.45 and $2.65 (see slides 60-85) in fiscal 2020, growing modestly to a range of $2.50-$3.00 by fiscal 2022. It's only because Macy's profitability surged well above expectations in 2021 and 2022 that its current performance seems disastrous.

Based on its Wednesday closing price of $11.82, Macy's stock trades for just four times its projected 2023 adjusted EPS. By contrast, Macy's shares traded around $17 immediately after the company's investor day in early 2020: nearly seven times its projected earnings for that year. That multiple compression has come even though Macy's has reduced its debt by over $1 billion since the beginning of 2020, strengthening its balance sheet.

Macy's is also on track to produce solid cash flow this year. Last year, free cash flow totaled just $320 million, due to high CapEx and working capital headwinds. In the first half of fiscal 2023, free cash flow was down $14 million compared to the same period in 2022. However, based on the company's current guidance, Macy's CapEx will total less than $400 million in the back half of the year, compared to more than $700 million in the second half of fiscal 2022. That will allow the company to generate ample cash despite its earnings headwinds.

The real estate still holds tremendous value

While Macy's acknowledged last month that the real estate market is under pressure because of high interest rates, the company's real estate portfolio remains extremely valuable. That's particularly true because Macy's has the luxury of time. With consistently positive free cash flow, the company can wait out the current market cycle and increase the pace of asset sales whenever interest rates start to moderate and buyer interest picks up.

In April 2020, during the worst part of the COVID-19 pandemic, I estimated that Macy's real estate was worth at least $10.3 billion . While Macy's has sold over $400 million of real estate since then, I still believe its real estate (consisting of more than 300 owned store properties, approximately 100 ground-leased stores, and a dozen owned supply chain facilities) is comfortably worth $10 billion, and possibly more.

To be conservative, my 2020 estimate assumed that the COVID-19 pandemic would decimate the mall industry: even A+ and A++ properties. However, highly productive malls have thrived since 2021, and leasing demand has remained exceptionally strong even in 2023. As a result, Macy's owned real estate in high-quality malls is likely to be significantly more valuable than I posited.

Continuing strong demand for industrial space likely makes Macy's supply chain real estate even more valuable than my previous $1.3 billion estimate. And changing demographic trends have boosted the value of Macy's real estate in many Sun Belt markets. For example, Seritage Growth Properties ( SRG ) sold a vacant former Sears store at a low-quality mall in South Florida for $16.5 million last quarter, despite the headwind posed by high interest rates.

On the flip side, some of Macy's properties in coastal markets may be worth less than I had projected: particularly the San Francisco flagship store. This shouldn't be overstated, though. Last year, Macy's sold a 12-acre parcel at an Orange County, California mall slated for redevelopment for a hefty $49 million .

Notwithstanding these puts and takes, Macy's real estate would likely fetch at least $10 billion in an orderly sale, and possibly quite a bit more. Meanwhile, the stock's 2023 plunge has reduced its enterprise value to less than $6 billion: a level only previously seen during the early days of the pandemic. That provides a sizable margin of safety for investors.

Hasn't this been tried before?

Some readers may recall that activist fund Starboard Value invested in Macy's in 2015 and pushed to spin off the company's real estate and sell stakes in its properties to JV partners. Macy's evaluated and declined the proposal, and Starboard Value subsequently exited the stock at a loss in early 2017.

A lot has changed since then. Most notably, when Starboard Value began accumulating shares in the first half of 2015, Macy's carried an enterprise value of nearly $30 billion. Even Starboard Value's overly optimistic valuation of $20.7 billion for the company's real estate couldn't justify buying the stock without believing that the underlying retail business was quite durable and valuable.

At a sub-$6 billion enterprise value, the calculus is much different. If the retail operations recover nicely from the current downturn, investors will be handsomely rewarded (and there will still be excess real estate that Macy's can sell over time). And if the business continues to decline, Macy's can pivot towards monetizing its real estate to create value for shareholders.

This isn't Sears

One piece of pushback I often get when discussing Macy's real estate is that Sears Holdings went to zero despite supposedly having substantial real estate value.

There's one huge difference between Sears and Macy's, though. Sears' operating cash flow turned negative in 2011 and never returned to positive territory. Between then and late 2018, when the company finally filed for bankruptcy, Sears used nearly $10 billion of cash in its operations. Even with low CapEx (which likely accelerated its decline), Sears needed to monetize its real estate and brands at a rapid pace just to keep the lights on. As a result, there was nothing left for shareholders in the end.

By contrast, Macy's has averaged operating cash flow of more than $1.6 billion over its past three fiscal years (a period that includes the pandemic year of 2020). Operating cash flow is on pace to reach a similar level this year. Positive cash flow means that Macy's is generating more intrinsic value for long-term shareholders each year, while its real estate should at least maintain (if not grow) its value over time.

What are the risks?

There are two major risks for long-term Macy's shareholders, in my opinion. The first is that real estate values never fully recover, due to interest rates remaining high and the rise of remote work reducing the value of city center real estate.

I have estimated that Macy's downtown flagships are worth at least $4 billion, with the Manhattan flagship accounting for most of that value. Prior to the pandemic, a $3 billion-plus valuation for the 2.2 million square foot Manhattan store was well supported by comparisons, such as Amazon's ( AMZN ) early 2020 purchase of the nearby Lord & Taylor flagship for approximately $1,450 per square foot. But if that property turns out to have a much lower value going forward, it could significantly reduce the margin of safety for investors.

The second major risk is that Macy's financials deteriorate and the company starts burning cash rapidly, like Sears a decade ago. That said, Sears had a stubborn controlling shareholder in Eddie Lampert who frittered away the company's real estate value in the pursuit of a doomed strategy to transform Sears Holdings into an asset-light " integrated retailer ".

By contrast, with its beaten-down valuation and massive real estate trove, Macy's looks like a prime target for an activist investor today, particularly if performance deteriorates further. If management can't generate consistently positive free cash flow while implementing its growth plan, shareholders are likely to replace them with a new team focused on cutting costs and monetizing real estate.

A valuation too good to pass up

Covered land plays are attractive investments because they generate cash flow in the near term (as opposed to vacant land that has carrying costs) but can be redeveloped for better uses at an opportune time in the future.

Macy's fits this description well. The company consistently generates cash, but free cash flow is fairly low relative to the value of its assets and its cost of capital. This indicates that many of the company's assets are not currently being put to their best and highest use.

Even if Macy's engineers a strong turnaround, the company will be able to opportunistically sell excess real estate (typically at lower-quality malls) for redevelopment in the coming years. That will supplement the company's free cash flow, enabling Macy's to return lots of cash to shareholders. And if the business continues to struggle, the company could shrink the store fleet significantly, generating billions of dollars in asset sale proceeds.

In a worst-case scenario where earnings and cash flow go downhill rapidly, Macy's could follow the example of Alexander's ( ALX ) by shutting down its retail operations and pivoting entirely to capitalizing on its real estate value. At an enterprise value that is barely more than half of its estimated real estate value, Macy's stock looks like one of the most compelling bargains in the market today.

For further details see: