M - Macy's: At An Inflection Point Initiate At Buy

2023-05-09 04:40:49 ET

Summary

• Macy's has been under significant pressure due to weakened consumer sentiment that has ravaged retail spends, in particular, department stores.
• Given the current rout in stock prices, we believe there is a favorable risk-reward to buy.
• Macy's is poised to come out stronger in this dynamic environment on the back of balance sheet strength, operational discipline and continued digital growth and loyalty subscriber base.

Background

Macy's (M) has been gaping with a structural slowdown within the department sector with sales reeling under pressure from competition as well as consumer shift towards digital and frequenting the malls less often. However, the company, despite 40% down from the pre-pandemic levels, remains one of the better performers relative to its peers. With consumers increasingly becoming wary on their spends on the back of inflationary headwinds, department store continue to struggle, albeit some more than the other. However, M has been able to weather the storm through a series of structural changes it enlisted as part of its Polaris strategy that the company embarked upon in 2020. Its focus on operational discipline (inventory levels down ~20% below pre-pandemic levels), store optimizations (closing about 80 full size stores since 2019 and more to come) and shift to off-mall expansion and strong balance sheet with Debt/ EBITDAR at ~2x and no material maturities until 2027 makes it the strongest player within the department stores category.

Polaris Strategy

M initiated a foundational change beginning 2020 through its three-year Polaris strategy to stabilize profitability and position for the company's growth laying down a five-pronged actionable.

1) Curated fashion products : The company continued to reach a broad category of consumers by offering them a wide assortment of products ranging from off-price to luxury. It is evidenced by better comp sales growth over 2019-2022 compared to its peers and M's (0.5%) average growth in 2017-2019 period.

2) Accelerating digital growth : Digital penetration improved significantly from 25% in pre-pandemic era to about 38% currently. It also launched Macy's Media Network (MMN) in 3Q20, its in-house media agency that enables B2B monetization of advertising partnerships. MMN delivered a robust $140 mn+ sales in CY22 with most of it flowing into EBIT dollars. Its ongoing investments (~$1bn in 2022) in enhancing omnichannel capabilities, data analytics and digital and supply chain modernization has led to increased engagement, loyalty members (~90% omnichannel customers are loyalty members) and higher average basket as well as increased frequency.

3) Customer relationship : It focused on driving loyalty programs and building customer lifetime value through its Star Rewards loyalty program which enabled them to increase its customer base by ~20% vs 2020. Almost 70% of the customers that has shopped from Macy's are its loyalty program members which is a significant boost driving engagement and enhancing average basket.

4) Optimizing Store Portfolio : M has closed about 80 full size stores (of the 125 stores planned) which had been significant underperformers and plans to close 5 more this year. Its focus continues on expanding its off-mall footprint, with plans to open further over Backstage and Marketplace by Macys stores, which could pe pivotal in current scenario, albeit at a small scale. It also introduced 'Toys-R-Us' shops within all locations leading to toy sales volume doubling compared to last year.

5) Supply Chain Transformation: Management has continued to manage better inventory (exiting 2022 inventory at 18% decrease compared to pre-pandemic levels) and has focused on creating mini-fulfillment centers in select stores to build faster and more efficient network. It converted space in 25 stores to serve as mini-distribution centers, thereby boosting its distribution space by a staggering 1mn sq. feet enabling the stores to be improvise delivery speed and reduce shipping costs.

What is Management Doing?

Management expects retail spends to be under pressure due to persistent inflation outpacing wage growth that has tightened consumer wallets ravaging department stores and Macy's along. It expects about 6% decline in comp sales for Q1, lapping with about 13% sales growth YoY, and further expects a 2% decline (at midpoint) for the year. Footfalls also continue to be under pressure, down about 20% average YoY, according to the data from Placer. ai while web traffic has also slowed, although it has remained positive YoY which is a silver lining. However, in this dynamic environment it had laid out five vectors that can fillip the company by 1) Enhancing private brands (which is already ~16% of 2022 sales) and driving gross margins 2) Digital growth by adding an incremental 2,000 brands vs 500 currently, driving higher order values 3) Personalized and targeted promotions driving engagement and loyalty and 4) Continued off market expansion. Category mix, balanced assortment and continued focus on digital and off-market focus would enable the company to weather the storm.

Why is it a Buy?

M stock trades at a very attractive 2.5x EV/ EBITDA currently, the lowest compared to its peer set despite being one of the better positioned. M has traded at a premium to KSS during the pre-pandemic time period, baring 2018-2020 period where in it underwent an existential crisis. However, the company makeover and shift in strategy seems to bode well on the company and we believe a 25% discount to its 10 year trough to its pre-pandemic levels factoring in the current subdued environment (historical average is of ~4.3x at the troughs between 2011-2020, while 10-year median during the same period is about 5.9x) warrants a favorable risk reward at 3.2x EBITDA. Given better leverage metrics, operational discipline, digital and omnichannel growth leveraging data AI and analytics, we believe the company is poised to weather this dynamic environment and the current downturn in the stock price warrants a strong buy. We initiate with a target price of $21 at an attractive 3.2x EV/ EBITDA.

Risks to the rating include 1) subdued economic environment amidst higher inflation for a prolonged time affecting consumer spends 2) competitive pressure from other department stores, off-price retailer and online could further put pressure on margins and 3) inability to maintain inventory and merchandise mix providing balanced assortment of products.

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