Macy's (NYSE: M) stock price has been in a precipitous decline for the past five years. After reaching its all-time high of $72.31 on July 13, 2015, the price shed more than 75% of its value. Macy's stock price hasn't been this low since the financial crisis in 2008. And before then, Macy's traded at a similar price more than 20 years ago in 1997. So, with the consumer discretionary stock's price down so much, plus a dividend yield above 9%, Macy's seems to be pricing in a lot of bad news. Are investors overreacting to Macy's outlook?
The big picture in perspective
Anyone not living under a rock knows that Macy's business model is under pressure from the rise of e-commerce. Macy's sales have declined at a compounded annual rate of 2.2% over the past five years. But that's not horrible. Further, gross margins have stayed relatively stable in the 39% to 40% area. Again, not the worst seen in the retail sector.
On a brighter note, same-store sales were actually positive in 2018, and were positive for seven consecutive quarters until the recent third-quarter comps came in below expectations at negative 3.5%. Reasons for the weakness included soft international tourism, weak lower-tiered mall performance, and the late arrival of winter. At least part of that should be transient. Still, the disappointing third-quarter contributed to Macy's lowering its full-year comparable store guidance to a negative number, versus positive guidance it previously issued. It also lowered its EPS guidance for the second time in as many quarters, which is now 15% lower than where it started the year.
But Macy's isn't standing still. Starting in 2015, it expanded into the off-price segment launching a new store concept called Backstage. To date, it has opened 215 locations, with all but seven inside Macy's existing stores. That has three main positives. First, no additional real estate expenses are incurred to open those stores. Second, Macy's feels the new concept is increasing foot traffic in its traditional stores as cross-over sales are occurring with about 15% of shoppers. And third, the Backstage concept is performing well with comps continuing to grow in the mid-single digits. Then in 2018, Macy's started remodeling its top 150 stores under an initiative called growth 150. This initiative is also producing same-store sales comps above its entire fleet.
Further, guidance could now be conservative for the fourth quarter. CEO Jeff Gennette responded to a question on Macy's third-quarter conference call by saying:
We want to make sure that we have a fourth quarter strategy that we're very confident in, that we've been planning for. The confidence that you hear (on the conference call) is everything that Macy's and Bloomingdales can control on our side. But the macro conditions, anything that we can't control, we believe we have guidance that can -- that fits within all of those dynamics.
Long-term pressure is unlikely to abate
So, while the fourth-quarter may come in ahead of recently lowered guidance, there are a couple of key trends not to lose sight of. First, online retailing still only accounts for a low-double digit percentage of total retail sales. With online retailing still growing at mid-teen rates, market share gains from traditional brick-and-mortar stores should continue. And second, even a low-single digit decline in same-store sales can wreak havoc on Macy's financials.
Consider, Macy's total sales are only about $3 billion less than they were five years ago, down slightly more than 10%. But if it is unable to cut operating expenses by a similar amount, which is difficult for a brick-and-mortar retailer to do, the decline in gross profit drops to the bottom line. And the narrower the margins are, the greater the impact. Macy's cash flow from operations in 2013 was just over $2.5 billion. In 2018, cash flow from operations was just over $1.7 billion, a decline of 32%. And it's also worth noting that these declines occurred during a time period that included a sizable drop in Macy's tax rate, boosting cash flow by close to a couple hundred million dollars.
Worst still is that capital expenditures actually grew slightly over this period of time, from $863 million in 2013 to $932 million in 2018. This means free cash flow dropped from $1.7 billion to $800 million -- a 52% decline, which matters. Free cash flow is what buys back stock, pays down debt, and pays out the dividend...at least on a sustainable basis.
And that brings us to the dividend. Macy's paid $463 million out in dividends in 2018. That's pushing almost 60% of its free cash flow, up substantially from just a few years prior. Is the company concerned? Well for starters, its last dividend increase was in the second quarter of 2016. Regarding its commitment to the current dividend rate, Macy's CFO Paula A. Price said on the conference call:
"So specifically to your question around dividends, our board approves our dividends quarterly. We review that with them. And we don't have plans near-term to change our dividend, but we continue to evaluated it in the context of our capital allocation as well as our strategic plans more broadly. And so we're well aware that with the drop in our share price, our dividend yield is now outsized. But having said that, dividend yield is but one metric that we think about when we're thinking about our dividends and our dividend policy, and it's not one that we wholly control."
That type of commentary doesn't inspire the strongest confidence that the dividend is sacrosanct. In my opinion, a dividend cut in the next couple of years would not be surprising.
Best to wait for more stability
Macy's may have a strong fourth quarter, at least relative to recently lower guidance. But the long-term negative trends pressuring its business are still firmly in place, and Macy's cash flow runway is getting shorter and shorter. Maybe it can pull a rabbit out of the hat. Investors will know more when it hosts its investor's day on Feb. 5.
If you are still interested in investing in Macy's, ask yourself one question: Why would a management team, with its stock price down 75%, suspend share repurchases and be focused on paying down debt? Could it be that it has concerns about the future of the company? If management were truly optimistic about the future and believed that its cash flows were sustainable, they would be doing the exact opposite, leveraging the company and buying back massive amounts of stock. So with regards to Macy's, at least for now, it's probably better to follow the old adage, 'there are easier ways to make money.'
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