M - Macy's: Property Portfolio Will Not Save It As Profitability Tumbles

2023-11-13 10:45:14 ET

Summary

• Macy's stock has continued to decline, with a high short interest indicating expectations of potential bankruptcy.
• Macy's sales have declined for over a decade, and its inflation-adjusted sales have dramatically fallen by around 3-5% per year.
• The decline in consumer demand and negative macroeconomic headwinds may lead to Macy's inability to earn an operating profit by next year.
• Given increased interest rates and weak use-value for department stores, I do not believe Macy's properties would sell for more than $4B.
• While economic trends could shift its prospects, I do not believe its equity value will be retained beyond 2026 and potentially earlier.

Earlier this year, I published "Macy's: Fighting To Survive, But Long-Term Turnaround Seems Unlikely" regarding my bearish outlook for Macy's ( M ). Since then, the company has lost 30% of its value, from $15.66 to below $11 today. When I covered the stock in May, it was trading at a very low "P/E" valuation of around 4X; however, I expected its EPS would continue to wane due to macroeconomic factors and its weak competitive position. For the most part, we've seen continued weakness in this segment of the retail consumer market since then. Further, Macy's stock valuation has continued to decline, now at ~3.9X on a forward basis. The stock also has relatively high short interest at 11.6%, indicating many speculators likely expect the company to go bankrupt sometime in the coming year or two.

Macy's is undoubtedly at the "make or break" point. If it crosses the threshold of financial instability, its ability to recover is minimal due to high interest rates and weakened investor appetite for risk. Despite its abysmal stock performance, the company still has a "BBB-" credit rating, which is a technical "investment grade," indicating a low chance of bankruptcy. One key factor contributing to that is likely the valuations of its property portfolio, being among the few retailers that still have significant property ownership today. The value of its property book is also the primary reason the stock may be undervalued today, particularly considering its core business appears unworkable in the modern market.

Given its position, I believe it is an opportune time to take another close look at the stock to determine if it is below, above, or close to its fair value. To do this, we must consider not only the company's fundamentals but also that of the department retail sector at large. In my view, although there is potential undervaluation in Macy's due to the value of its property portfolio, a continued decline in the department store retail sector will eventually cause its properties to be worth far less than many hope.

A Deep Dive into Macy's Core Business

Macy's sales have generally been on the decline over the past decade. As more people shop at Amazon or other e-commerce services, fewer are interested in going to department stores. Macy's remains the most prominent American department store chain and differs from some of its smaller peers by not focusing so much on luxury items. Smaller department stores with a luxury item focus may have some enduring value because people typically prefer to see high-cost items in person before buying. In contrast, many are comfortable buying mid-to-low items on the cheapest and easiest platform. As this competitive pressure mounts, Macy's sales have fallen, particularly on an inflation-adjusted basis. See below:

As discussed regarding Abercrombie & Fitch ( ANF ), investors should not confuse inflation for growth. Many retailers have had strong sales growth in recent years due solely to increased consumer prices, which have typically proportionately (or disproportionately) increased cost-of-goods sold. Macy's is among the few that have seen sales fall despite high inflation; thus, its inflation-adjusted sales have declined dramatically. In other words, the total items Macy's is likely selling remains on-pace with its historical range of about 3-5% per year on average over the past decade. I expect that pace to continue as the trend has been steady, with any potential fluctuations coming from changes in economic demand.

For the most part, the past decade, particularly the late 2020 to early 2022 period, was great for retail sales. However, as consumer prices rose, many households saw savings levels decline and increased consumer debt. With prices still growing at an abnormal pace and interest rates much higher, we're seeing a sharp decline in savings and consumer credit. I believe this is a solid indication of an impending decline in discretionary spending. See below:

The past five years have been highly volatile for US households due to the series of sharp fluctuations in demand, driven initially lower by lockdowns, higher by stimulus, and then lower again by inflation. Changes in real retail sales are primarily a function of personal savings, consumer sentiment, and consumer credit changes. Low personal savings can be offset by high consumer credit growth, as people use credit cards to maintain excessive spending. To a large extent, retail sales in 2022 were supported by immense consumer debt expansion. Today, consumer debt is starting to decline despite no increase in personal savings, indicating an even sharper decline in discretionary consumer spending.

Of course, the data above does not consider the potential fallout from the October student debt repayment continuation. The impact of this issue may be tempered by the expansion of IDR plans . However, even a $50-$200 decline in discretionary income amongst a large portion of working adults is likely to impact retailers negatively. Growing weakness in consumer credit has a dual impact on Macy's because it will not only slow its sales but also increase its losses on sales as more people default on Macy's credit cards. In Q2, the company saw a spike in Macy's card delinquencies , a trend which I expect accelerated in Q3, given the US average delinquency rate increase in Q3. We also see issues in auto loans, with most US consumer debt issues stemming from the "artificial" boost in consumer credit ratings from the 2020 stimulus, leading to potentially widespread declines in lending standards.

While Macy's may appear to have a low valuation today, its ability to continue to earn an operating profit is minimal if it cannot stem losses in gross profits. Its gross profits declined by around $1B on a TTM basis from Q2 2022 to Q2 2023, during a relatively stable period for national consumer spending. Its working capital and cash position are also meager compared to past levels, limiting its liquidity position that could extend its life. That said, its inventory level is also low, potentially aiding a recovery. See below:

Typically, gross profits are more volatile, while operating expenses are challenging to lower without suspending operations. As such, if Macy's gross profits decline by another ~$1B over the next year, its operating profit would be roughly zero. Its net income would be negative due to its ~$160M annual net interest expense. The analyst consensus view is that Macy's EPS will instead fall to ~$2.70 per year by 2024 with a long-term stable revenue of around $23.1B. That estimate gives M a two to three-year forward "P/E" of 4-4.15X, which is below that of Kohl's ( KSS ) and Dillard's ( DSS ), both around ~7X .

However, while that may make Macy's seem undervalued, I believe it is most likely that Macy's will soon be unable to earn an operating profit due to the adverse macroeconomic headwinds starting to accelerate against it. This is on top of its ongoing competitive struggle against e-commerce and smaller retailers, as well as the macroeconomic decline in consumer demand forced by people reaching credit card limits .

Can Macy's Property Assets Redeem It?

In my view, it is most likely that Macy's will fall into chronically negative operating margins by 2024 or 2025, based on macroeconomic trends and its consistent fundamental trends. Currently, the company is racing to triple its small-format stores by 2024, opening around 30 locations across the US, around one-fifth the size of its traditional stores. That is combined with its efforts to expand its online shopping platform, which has struggled tremendously .

In my view, Macy's effort to focus on smaller stores is an excellent example of " too little too late, " as it should have pursued that course a decade ago when it began to face significant competitive difficulties. Doing so today creates another uphill competitive battle against smaller retailers and draws on Macy's capital needs when it lacks sufficient liquidity. Its CapEx is now running at around $1B annually and could rise as it continues to try to shift its focus toward smaller stores. The fact is that with just ~$440M in cash and falling operating income, it will likely soon need to sell equity or try to raise more external debt to try to fund this doubtful shift.

Further, the fact that it is focusing on much smaller stores indicates its real estate portfolio may not be worth much, as it is costly to renovate substantial department stores to something more feasible. Macy's properties are marked at ~$5.88B on its balance sheet. Early estimates years ago placed its estimated property fair value at $21B, but it has sold much since then, while the performance value of its properties has dwindled. Recent 2022 estimates give its real estate a more reasonable $7B fair value.

Of course, since 2022, higher interest rates have caused commercial properties, on average, to lose around 19% in value . As capitalization rates rise proportionately to real rates, I would not be surprised to see a 40% overall decline by 2025 unless commercial mortgage rates decline. Further, a continued decline in consumer demand, particularly for department stores, should push the value of large department store properties even lower. With retail theft rising quickly, I do not believe most department stores will exist by 2030. Many failed department stores and malls have very little enduring property value and are likely to remain abandoned, with others being sold at a 94% loss .

Not considering that risk, interest rates alone should lower the value of Macy's property portfolio to an estimated $4.9B, 30% below its $7B past target, reflecting the broad decline in commercial property values due to interest rates. Of course, should Macy's continue to see its operating income decline and need to sell its properties to improve its capital position, then the value of its properties will likely also decrease as the department store industry's long-term survivability becomes questionable. Considering the vast costs of potentially restoring department stores to a more useful asset , some of Macy's properties could be a net liability in the event of Macy's potential failure. Thus, I believe Macy's properties would yield no more than $4B from a liquidation standpoint.

The Bottom Line

Macy's is trading at $3B with a tangible book value of $2.95B. Adjusting its tangible book value for my property "liquidation" value estimate, its NAV target would be only $1.12B. Thus, I believe that Macy's is overvalued both from a balance sheet standpoint and an income view, given that its book value is above its NAV and its income is unlikely to remain positive next year. Accordingly, I expect M to lose its remaining value at some point in the next three years, with a bias toward 2024, given we see a recession in consumer spending. In my view, based on robust data-driven models , the odds of a recession next year are likely around 50%.

I am very bearish on M and expect the stock will continue to lose value over the coming quarters. Many other analysts will not realize my property value estimate until market participants realize the full extent of the interest rate shock of commercial properties. Thus, I would not be willing to bet against Macy's should its value decline below $2B or a stock price of $7.30. Even then, Macy's is too volatile for me personally to short-sell it, as its high short interest level could result in a spike if its Q3 report this week is stronger than expected. Given my understanding of the credit card issue, I hope its Q3 report will be weaker than expected; however, temporary outperformance is also possible.

For further details see: