Can This Retail King Survive a Sector in Turmoil?

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Macy’s (NYSE: M) poses an interesting question to investors: what is the value of being a well-run company with a dominant position in a sector that is stuck in long-term decline?  Can management maintain the laser focus needed to deliver compelling shareholder returns in the absence of growth drivers?  

Department stores may be in decline as a retail format in the U.S., but Macy’s has won the sector nonetheless.  It has become the well-run behemoth that, while larger than competitors Saks ) and Dillard’s (NYSE: DDS), approximately the same size as competitor J.C. Penney ) and approximately half the size of competitor Sears Holdings ), is better run and shows superior profitability all either.  But is that truly enough?

  • Saks: Few things are better than profitable growth, and in the past few years Saks has had it.  Revenue is up nearly $400 million, or 14.5%, between FY09 and FY11 (from $2.6 billion to $3 billion).  Meanwhile, gross margins have rocketed by over four percentage points, to 40.8% from 36.6%.
  • Dillards: Not much growth here, revenue is up less than $200 million, or 2.8%, between FY09 and FY11.  The company did manage to show gross margin improvement, with gross margins rising to 36.8% from 34.1%.   
  • J.C. Penney: Looking at historical performance makes no sense for a company in the midst of a radical makeover like J.C. Penney.  Sales were over $17 billion in FY11, once CEO Ron Johnson is done with his turnaround, who knows?
  • Sears Holdings: It takes a special kind of leadership to render a $40 billion retailer irrelevant.  But that is just the kind of guy Chairman Edward Lampert is.  With FY11 sales of $41.6 billion, this company has lost $1.8 billion, or 4.1%, of sales since FY09.  Oh, and gross margins are down over two percentage points, to 25.5%, from 27.6%.  

The troubling fact is that there is nothing about Macy’s to get investors hearts racing.  This is a boring company without much buzz.  Growth stories are sexy.  Car wrecks in progress are morbidly fascinating.  Turnarounds can be sexy (and at a minimum offer the potential to become car wrecks, and hence become morbidly fascinating).  But moderately valued, well-managed companies in a profitable holding pattern offer little to inspire the imagination.  This is not an investment that will prompt spirited conversations, but the best investors know that boring is not always a bad thing.

Macy’s CEO Terry Lundgren presides over the king of U.S. department store retailers.  With 842 locations and sales of over $26 billion, Macy’s is the dominant player in this troubled sector.

  • Sales: Over the past five years sales have essentially been flat, with 2011 sales at $26.4 billion and 2007 sales at $26.3 billion.  Given the severity of the 2008-9 recession, and the challenges of the department store sector, flat sales are an accomplishment.  Nonetheless, investors need to keep in mind that there is no credible growth story here. 
  • Profitability: Creating value in mature companies or turnaround situations comes down to blocking and tackling, and the Macy’s team has done an admirable job.  Gross margins have held steady, and in 2011 were at the same 40.4% level of 2007.  The operating margin, however, has increased two percentage points over that five year span, to 9.1% from 7.1% in 2007.  
  • Cash Flow: Operating cash flow is strong, reaching nearly $2.1 billion in fiscal 2011.  Capex has trailed depreciation over the past three years by a cumulative $2.2 billion.  This could signal an intention to consolidate physical locations, or simply the fiscal discipline of a management team that understands its industry and is focused on generating maximum value for shareholders.  The company’s financing approach is restrained, with dividends and share repurchases held to moderate levels.
  • Thesis: In spite of a 26% run up in the share price over the past 52 weeks, Macy’s represents good value for investors.  With an Enterprise Value / EBITDA (ttm) of approximately 6.0x, strong Return on Equity (22.6%) and a Dividend Yield of 2%, this is a company that investors should be comfortable holding.

Recommendation: Macy’s faces a valuation challenge when compared to its more troubled department store competitors.  It is the dominant player in a niche that is out of favor, and there is no growth catalyst on the horizon.  Management has demonstrated an admirable ability to sweat every dollar of revenue for maximum profitability, and shareholders have and will continue to be the beneficiaries of that focus.  This is a solid investment with good though not stellar upside prospects.  However, in the case of another U.S. recession investors would likely take a severe hit.  On a risk/return basis Macy’s is not a bad place to park some money, but this is not a home run, it is a single, or at best a double.

Conclusion

An investment in Macy’s represents a bet on the ability and willingness of management to continue to grind out gains for shareholders in the most difficult of ways.  The store count must be carefully managed, likely shedding stores slowly over time as the company continues to develop and refine its omni channel marketing strategy.  Careful attention must be paid to the merchandise mix, opportunistically layering in house brands in order to boost gross margins.  Long term obligations such as leases and pensions need to be carefully attended to, and renegotiated when opportunities present themselves.  A tight rein must be maintained on spending, and investment must be focused on the highest return opportunities.  Company management must also carefully weigh the long-term impact of its dividend and share repurchase policy over the needs of investors to realize a reasonable return on their investment.  In short, Macy’s can work as an investment, but only to the extent that leadership does not give in to the temptation to swing for the fences or look for a quick fix.      


StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Dillard's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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