Macy’s is probably a dying business. They epitomize the American big-box retailer that is under attack. It’s a business that is mostly undifferentiated from any other large department store, yet more depressingly has continued to remain so.
Tery Lundgren has been the CEO here since 2004. He has written books, received philanthropic honors from Carnegie, been endowed with medals from the National Retail Federation, and is the appointed Commissioner on Women’s economic development in New York City. What Tery didn’t do while running Macy’s was manage the business successfully for its owners. During Tery’s tenure, the owners of this business made no money. Actually, that’s harsh. Owners of the business made about 1% per year during his ~13 year tenure. The entire return came from dividends as the stock dropped by -15%. Terry did about as well as a Wells Fargo checking account. A decade ago, as the head of one of the largest retailers in the USA, Tery watched as the internet starting taking over retail, watched as internet retail grew, watched as his customer’s preferences changed, then finally decided to act two years ago once internet retail had already reached its tipping point and won.
Don’t feel too bad for Tery and his performance in line with your checking account. Over the past five years, he’s made $67.5 million dollars. Including $11.7 million in 2015 while the owners of the business he has been hired to manage experienced losses of -45%. Over the past two years, Macy’s stock has fallen -65% while its net income has been cut in half. This is no country for old men. Tery seems to agree, has patted himself on the back with a giant change of control golden parachute, and has decided to hand over reigns to a successor this year and step into the Chairman role. I do not envy that successor, Jeff Gennette. People like Tery are among my least favorite in this world – full of entitlement, contradictions, and filled with economic and political poison. I could go on and on and on, but I’ll refer you here for generalities.
Amazon and other internet retailers have already eaten the lunches of businesses like Macy’s and have started eating their dinners. The retail world is terrified of this trend continuing. Every time Amazon speaks about brick and mortar stores, the retail industry and its owners panic. On June 16th, the morning after Amazon announced it would purchase Whole Foods, the market reacted:
- Kroger (NYSE: KR), down 13%
- Wal-mart (NYSE: WMT), down 5%
- Target (NYSE: TGT), off 9%
- Costco Wholesale (NASDAQ: COST) down 7%
- SUPERVALU (NYSE: SVU) down 16%
- Sprouts Farmers Market (NASDAQ: SFM), down 12%
- United Natural Foods (NASDAQ: UNFI) down 15%
- CVS Health (NYSE: CVS), down 4%
- Walgreens Boots Alliance (NASDAQ: WBA) down 4%
- Dollar Tree (NASDAQ: DLTR), down down 4.5%
This reaction to the move by Amazon wiped tens of billions of dollars in market value off of the retail sector in just a couple hours. Thanks to the fear bred by Amazon, small online retail outfits are getting swallowed up by large bricks and mortar stores at high and asinine valuations stemming from hopes that these large dying businesses can buy their way out of their woes to compete in the new landscape.
Despite the above, I have no strong opinions about the future business viability of Macy’s. Although, as the title of this post suggests, it could be a zero. What I care about are Macy’s assets – and they have some good ones.
I am long the Macy’s Senior Unsecured 2043 bonds at $79 and change. The yield to maturity is about on parity with a preferred stock at ~5.7%. As they’re long-dated bonds, comparing them to preferreds is how I’m positioning them. These bonds are covenant-lite, are the highest in the capital structure, and contain a change of control provision that might provide a quick 25% capital gain as the CoC requires a payout at $101. A liquidation would probably be the ideal scenario as the asset coverage is (in my opinion) much more than debt outstanding.
In 2015, Starboard Value bought up a chunk of Macy’s stock and went activist on the company. They pushed for board seats and sought to split up the company with the focus on unlocking the value in the huge real estate holdings within Macy’s. Starboard lost, and Lundgren and his pals kept their high salaries, board seats, power, and the pathetic status quo.
At the time of Starboard’s activism, I thought they were a bit too rosy on Macy’s prospects. Luckily, optimism has continued to fall out of prices while the media and Amazon continue to pound on the bricks and mortar names. This has allowed pessimism a greater hold. Hence, the margin of safety looks much stronger here.
Starboard was long the common stock, and their optimism and pricing expectations reflect that. Starboard estimated Macy’s real estate is worth $21 billion. I’m not long the stock and I don’t think the real estate is worth $21 billion. I don’t care if the common stock goes to zero – and I might actually prefer that outcome. All I really care about is that Macy’s assets are comfortably worth more than their debts, and I care that it stays that way. Macy’s outstanding debt is $6.3 billion dollars. Net debt is lower, at something like $5.6 billion.
Now, Starboard is a sharp shop. But let’s assume they were way too optimistic or that real estate markets cool considerably at some future point from when Starboard presented their analysis (Q1 2016). For simplicity, let’s say the real estate is only worth half of what Starboard estimated. Half means $10.5 billion in real estate vs $5.6 billion in net debt – which still provides a large margin of safety for an eventual par recovery on the debt. But that’s just using Starboard’s values.
The Real Estate
Since Macy’s founding 158 years ago, the company has amassed a huge portfolio of real estate holdings. A number of these locations aren’t worth much considering the glut of JC Penny, Sears, Dillards, etc. that are on the market in low-tier or Class B and C malls for $10/ft. What matters is the real estate Macy’s owns in NYC, San Francisco, Chicago, Minneapolis, and its owned stores in tier 1 or A+ malls. I’ve broken this down into four main pieces:
First, Herald Square. This is one of the most iconic pieces of real estate in the country. It’s basically a trophy piece that has massive amounts of untapped value in a liquidation or in some other creative use of the property using air rights. It’s 2.2 million square feet and occupies an entire Manhattan block in one of the most desirable areas in the city. With Rent at $65/sqft and a 4.5% cap rate, we’re at $3.13B in value. That may sound like a lot, but that’s somewhat conservative considering recent transactions in the area. It comes out to $1400/sq ft. I can think of a few Chinese and Canadian companies that would jump at that price.
Second come the seven major downtown locations which include Union Square in San Francisco, State Street in Chicago, and Downtown Minneapolis. These seven stores make up 6.3 million square feet. At a conservative $20/ft in rent and a 5% cap rate, these stores add $2.5 billion in value. That comes to $400/sqft.
Third, Macy’s has 76 million square feet of owned mall space. This includes 407 locations. If we assume rent at $4/ft at a cap rate of 10%, these properties are worth $3 billion. That’s $40/ft.
Finally, Macy’s owns 14 Bloomingdales locations at 3.2 million square feet and has 105 ground leased Macy’s and Bloomingdales at 19 million square feet. 3.5 million square feet of tier 1 or A+ leases and 17 distribution centers. Starboard values all these at a combined $4.4 billion dollars. We’ll say, $1.5 billion for conservatism and brevity.
Using our very conservative valuations, we get a combined asset total of $10.1 billion. If I’m still far off, the margin of safety is substantial.
The question an investor must ask themselves is: Am I okay earning roughly 5.7% on this bond if no catalytic event (such as a change of control or liquidation) happens?
Macy’s is not dead yet. In fact, they still have about $25 billion in revenues and $600 million in profits. For the debt investor who might consider EBITDA, last year Macy’s produced about $2.4 billion. These bonds could very well last until maturity.
Let’s run through a few assumptions and assume Macy’s turns around the business and the bonds move back to par. Ignoring interest rates and what that might do to the bonds, and ignoring taxes, our return will be a combination of capital gain and the income (yield) on the bond.
If the hypothetical return to par takes five years, your annual return will probably be around 9.2%
If that takes 10 years, 7%
15 years, 6.3%
Here’s to hoping for a liquidation or a change in control (combined with a credit downgrade).
*Remember upon maturity the bond will pay $100. Change of control pays $101 but requires a simultaneous credit downgrade.
***As is forever and always the disclaimer, this is not investment advice. Do your own work and verify your own numbers. I might buy, sell, or ignore anything at any time and have no obligation to update anything on this site. I won’t be held hostage by commitment and consistency bias.***