Image Source: Macy’s Inc – IR Presentation
By Callum Turcan
Retailers (XRT, RTH) have been struggling as the e-commerce shift has stressed margins and hurt foot traffic at stores and malls all across America. Macy’s Inc (M) had fared better than most, but that’s beginning to change. The company reported second quarter FY2019 earnings on August 14 which came with a guidance cut that saw shares of Macy’s plummet below their late-2017 lows. While Macy’s recovered throughout the trading day, the market is clearly signaling that investors are expecting more pain is ahead. As of this writing, shares of Macy’s yield ~9.0%, a major red flag.
Guidance Cut
Management cut earnings guidance for the full fiscal year while keeping estimates for flat revenue growth and marginal same-store sales growth the same. Adjusted EPS guidance (non-GAAP) for FY2019 was lowered to $2.85 – $3.05 from $3.05 – $3.25 previously. For reference, Macy’s adjusted EPS came in at $3.79 and $4.18 in FY2017 and FY2018, respectively. The cut for this fiscal year was largely due to Macy’s weak showing in the second quarter.
Part of the earnings cut was due to Macy’s need to mark down prices to move inventory, which cut its gross margins by ~100 basis points during the second quarter. Weak sales of warm weather apparel, a miss on women’s sportswear fashion, and an “accelerated decline” at Macy’s international tourism business all dragged down the retailer’s performance in the second quarter of FY2019.
Image Shown: Macy’s cut adjusted EPS guidance for FY2019, which implies a material drop from its FY2018 performance. Flat revenue guidance, gross margin pressure, and rising SG&A expenses all signal there’s likely more pain yet to come. Image Source: Macy’s – IR Presentation
Going forward, Macy’s expects that its gross margins will continue to come under pressure in the second half of FY2019 while rising SG&A expenses are also at play. Furthermore, that doesn’t include the potential negative impact from additional US tariffs on Chinese imports. In its earnings press release Macy’s noted that (emphasis added):
“Macy’s, Inc.’s revised Adjusted Diluted EPS guidance does not reflect the fourth tranche of tariffs on goods from China. In light of the announcement by the United States Trade Representative on August 13, 2019, the company is evaluating the details of these tariffs and is actively working with its vendor partners and suppliers in China to help mitigate potential impact.”
We caution that when including the potential impact of additional tariffs on Chinese imports the Trump Administration has proposed, Macy’s outlook gets gloomier. Some of the proposed tariffs have had their implementation date pushed back to December from September, but most apparel imports from China (over three-quarters) will still be hit with the planned tariff increase. Management had this to say on the issue during Macy’s earnings conference call (emphasis added):
“We have confidence that our scale gives us the leverage to find mitigation strategies that work for us, our vendor partners and our suppliers in China. We know from the earlier tranche of tariffs though that today’s customer doesn’t have much appetite for price increases.”
Furthermore (emphasis added),
“So we are looking at then what is our risk for the way that its now been, because you have got some categories based on one fiber that’s being taxed or by on September 1st for the other same category, but different fiber that is being effected as of December 15th. So looking at all of that and I think we recognize that our risk to annual guidance in 2019 would be no more than one nickel [as it relates to adjusted EPS guidance].”
Even if Macy’s is sanguine about the impact additional tariffs will have on its financial performance in the short term, management was sure to highlight how over the long term (and especially at higher rates, particularly if additional tariffs increase from 10% to 25% on certain items from China), price increases couldn’t be ruled out. Considering the trouble Macy’s is having with passing on price increases to its customers at a time of low unemployment and rising wages in the US, that speaks to the deeper problems facing the retailer. Its GAAP gross margin declined by ~165 basis points year-over-year during the second quarter of FY2019 while its top line shrunk by about half a percent for reasons covered previously.
We aren’t fans of the multiline retail space and think structural problems facing the industry such as; high fixed costs, competition from e-commerce, and the growing tariff issue will stymie any attempt to turn these businesses around before the US economy experiences a sharp slowdown in economic activity within a couple of years if not sooner (considering we are late in the business cycle). Here’s a concise summary of our view on the industry from Macy’s 16-page Stock Report (that report can be viewed here):
“The multiline retail industry faces intense pressure from online retail and fierce competition from smaller retailers and discounters. Firms in the industry tend to have large real estate holdings and carry a diverse range of apparel, accessories, and household goods. With retail sales moving to the Internet, a company’s web presence is as important as its brick-and-mortar locations. The industry is undergoing a massive transformation and not all firms will survive. Brands and proper fashion assortment drive results in the short term, while execution remains key over the long haul.”
Watch the Debt and the Dividend
At the end of August 3, Macy’s had a net debt position of $4.0 billion ($0.7 billion in cash and cash equivalents less $4.7 billion in total debt). At the end of FY2018, which ended February 2, 2019, Macy’s had a net debt load of $3.6 billion. In FY2018, Macy’s generated $1.1 billion in free cash flow and spent $0.5 billion on its dividend. That makes Macy’s dividend coverage look better than it is, and we give the retailer a Dividend Coverage ratio of 0.3x due in large part to its hefty net debt load. It’s possible a dividend cut is on the horizon as Macy’s free cash flows have moved lower in recent years and its outlook doesn’t look great. In the graphic down below from Macy’s two-page Dividend Report (that report can be viewed here), we showcase why Macy’s dividend coverage is weak.
Image Shown: Macy’s doesn’t have good dividend coverage, largely due to its large net debt load and the deteriorating quality of its free cash flows. Image Source: Macy’s two-page Dividend Report
Concluding Thoughts
Here we must stress that if the US economy were to materially slow down, taking consumer spending and Macy’s financial performance with it, the retailer may be forced to cut its payout in order to preserve financial stability. Such a move would likely see shares of Macy’s plummet significantly lower as its technicals are extremely weak right now. We are staying far away from Macy’s and most retailers in general, but continue to like Dollar General Corporation (DG) as the nimble retailer has posted stellar performance since joining the Best Ideas Newsletter portfolio in April 2017. More on that here. With shares of Macy’s trading below the low end of our Fair Value Range as of this writing, its VBI of 3 screams Value Trap.
Food Retailing Industry – CASY COST CVS KR SYY TGT WBA WMT
Dollar Store and Department Store Industries – KSS M JWN BIG DG DLTR FRED PSMT
Retail – Apparel (Teen-30yrs, Off-Price, Outdoor) – AEO ANF BKE COLM GES GPS ROST TJX URBN
Retail – Apparel (Women’s, Men’s, Children’s) – CHS CRI GIL HBI LB PLCE
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Callum Turcan does not own shares in any of the securities mentioned above. Dollar General Corporation (DG) is included in Valuentum’s simulated Best Ideas Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.