M - Macy's: Management Needs To Show Value Beyond Takeover Offer

2023-12-12 16:14:49 ET

Summary

• Macy's share price surged after a takeover offer but concerns arise about the ability of Arkhouse Management and Brigade Capital Management to close the deal.
• Macy's sales decline continues, losing market share and struggling to appeal to consumers.
• The value of Macy's real estate adds complexity to its valuation, but analysts express caution over monetizing the real estate and completing the takeover.
• In my view, Macy's needs to show shareholders a clear path to recovery beyond the potential takeover.

Macy’s ( M ) share price soared after news of a takeover offer became public. The share price has since receded somewhat as there are growing concerns about the ability of Arkhouse Management and Brigade Capital Management to close the deal given their limited involvement with such large deals in the past. At the same time the offer raises interesting questions over what represents a fair value for Macy’s given its business outlook and the value of its real estate.

In August this year I wrote about a number of concerns surrounding Macy’s including strategic blunders by management around inventory and continued declines in sales. The sales picture remains a concern but there have been some positive signs around improving inventory management. These factors together with the value of Macy’s real estate leads me to consider the current offer to be too low while it also makes me wary that the stock could be in for a period of even greater volatility.

The sales picture and inventory management

In my earlier article from August, I highlighted the retailer's enduring challenges, including declining sales and market share issues predating the pandemic. Global Data reported that Macy's market share declined from 3.0% in 2016 to 2.5% in 2021. The company continued to face sales declines, which were not unique to it, as consumers, especially in the middle market segment, were becoming more cost conscious in their apparel spending. This shift favoured value-focused outlets, contributing to a 3% decline in sales for mid-market department stores at the time. At the time of my previous article in August, the outlook for substantial sales increases in the near term or a reversal of the declining trend seemed unlikely based on these observations.

In the third quarter the sales picture did indeed look bleak again for Macy’s with comparable sales declining by around 7%. However, this was a much lower decline in sales than in the second quarter when sales declined by more than 8%. The decline in sales continued to be most severe at the Macy’s brand while sales at Bloomingdale’s declined by a less severe 4.4% and sales at Bluemercury increased by 2.5%.

Neil Saunders has expressed the view that the third quarter sales data once again demonstrates the decline of Macy’s and how it has lost its appeal with consumers. He observes that while the industry at large has suffered from a challenging sales environment, Macy’s has performed much worse than its competitors and continues to lose market share. This weak sales picture might make several shareholders more interested in taking the offer currently on the table even if there could potentially be much greater value in Macy’s.

Importantly, one of the long-standing critiques of Macy’s has been the unappealing nature of its outlets. More recently management seems to have been taking some steps in the right direction and observed in its latest earnings call that –

In our second growth vector, small-format stores, we continue to open new Macy's and Bloomie's locations. As a reminder, these average roughly one-fifth the size of our full-line stores. Our portfolio of small-format stores continues to generate year-over-year comparable owned-plus-licensed sales growth. Customers appreciate the store environment, service, and ease of checkout, while feedback on shopping inspiration and styling ideas has been steadily improving.”

The early signs of success at these new format stores might well offer management valuable lessons that could be implemented at other stores. Investors will need to see clear avenues that could contribute to a recovery of Macy’s as a retailer to convince them that there's better long-term value in the stock than the offer on the table. The recent improvement in inventory management might also play a key role in demonstrating greater value in Macy’s.

In its most recent earnings call management noted that –

What's most encouraging going into the fourth quarter is how we think about our inventory. So, we start the fourth quarter in a solid inventory position. Inventory down 6% year-over-year, down 17% to 2019.”

While it remains to be seen if the strategic blunders around inventory experienced in the past have been fully addressed, the recent decline in old inventory is certainly a welcome development and could contribute to less discounting being required to sell old inventory.

Valuation and the takeover offer

Macy’s stock becomes particularly challenging to value given the value of its underlying real estate. Macy's owns valuable retail locations, including the notable Bloomingdale's store at South Coast Plaza and the massive Herald Square location in Manhattan, estimated to be worth between $3 billion to $4 billion. While there's disagreement on the exact valuation of Macy's real estate portfolio, with Cowen analysts providing a lower estimate of $5 billion to $8 billion for the entire portfolio, even the lowest estimates surpass the company's market capitalization and the recent offer made by Arkhouse Management and Brigade Capital Management.

Nevertheless, several analysts have expressed caution over the ability to monetize the real estate. The challenge with monetizing the underlying real estate is a key reason why Paul Lejuez , an analyst at Citigroup, has expressed skepticism over the ability of Arkhouse Management and Brigade Capital Management to close the deal. They similarly observe that the current high interest rate environment and underlying challenges in Macy’s core business may make it more difficult to complete the takeover.

Nevertheless, even with the slightly higher price after the takeover became known, Macy’s trades at a forward P/E ratio well below that of its peers. While this suggests that the stock is undervalued, this undervaluation is likely to remain as long as shareholders don’t have confidence in Macy’s core underlying business and the continued decline in market share within this business. It's imperative that management shows shareholders a clear path to recovery independent from any takeover which may or may not succeed.

Conclusion

The recent surge in Macy's recent share price following news of a takeover offer has been tempered by concerns about the potential challenges Arkhouse Management and Brigade Capital Management may face in closing the deal, given their limited experience with such large transactions. In my view, the deal seems less likely to materialize given these challenges and the increased difficulty in raising financing in the current market environment.

Nevertheless, the substantial value of the underlying real estate might well make it easier to obtain finance despite the challenges in Macy’s underlying business. That being said, I do not believe the price fairly reflects the true value of Macy’s but also don’t believe that anyone would be willing to pay the fair value for Macy’s in the current environment.

Reflecting on concerns raised in my August article, Macy's has grappled with strategic blunders, declining sales, and market share issues. While the third quarter did show a slight improvement in sales decline compared to the previous quarter, industry experts like Neil Saunders highlight Macy's continued struggle and loss of appeal with consumers.

Management's efforts in small-format stores and improvements in inventory management indicate potential positive shifts. The recent decline in old inventory, as noted in the latest earnings call, is a promising development, although the full resolution of past inventory challenges remains uncertain.

Despite the undervaluation of Macy's stock compared to peers, caution lingers regarding the ability to revitalize the core business independently of the potential takeover. Macy's needs to demonstrate a clear path to recovery, irrespective of the uncertain takeover outcome, to instill confidence in shareholders and address the persistent decline in market share.

For further details see: