I'm Looking for Some Magic From Macy's on the Long Side

 | May 15, 2017 | 10:30 AM EDT
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(This commentary originally appeared on Real Money Pro at 8:45 a.m. ET today. Click here to learn about this dynamic market information service for active traders.)

Buy at the sound of cannons? 

This morning Jim "El Capitan" Cramer wrote what many will be considered an audacious column, "Some Retail Stocks Are Oversold."

I believe Jim may be crazy like a fox. 

For more than three years I have avoided -- with the exception of a losing JC Penney (JCP) long -- the retail space (indeed, I have been consistently net short consumer discretionary), suggesting that there will come a time when investors panic and retail stocks may offer value. 

We are likely there, or at least close to being there now -- at a point in time when the maximum amount of pessimism may reside in investors' and trading thinking. 

This morning I will explain why Macy's (M) shares finally may be oversold. Having just purchased a small position, I am now long this name. 

Over the last six months Macy's shares have lost about half their value as the changing channels of retail distribution are pulverizing the department store industry.

The most important thing in analyzing Macy's quarter is that it is mercifully unimportant.

The earnings reported represent 6% of the full year's forecast. That said, it was bad and the stock has plummeted.

Sales fell 7%, with comps down 5%. This is a dreadful number, probably the worst in 40 years. However, there is plenty to be encouraged about. Sales, general and administrative (SG&A) ratios were flat, a great accomplishment given the operating leverage in this business. There was 1% gross margin pressure, but inventories appear to be statistically in line. EBID fell only 9%, a great number given the top line.

There is also a lot to be encouraged about on the financial front. Interest expenses were down 14%. The dividend was maintained and its full-year earnings guidance of $3.50 a share -- in the middle of the range -- was maintained.

Macy's is a cheap stock, trading at a 5x plus trailing 12-month EBITD multiple on $2.6 billion of EBITD. Current yield is 5.6%. Capital expenditures (cap ex) net of asset sales are in the area of $300 million to $400 million. There is a ton of free cash flow. (A competitor, Kohl's (KSS) , reported a reasonably good first quarter. The earnings multiple is half that of the market).

The magnitude of the weakness in Macy's may be unwarranted given a series of facts revealed in the conference call and discussed below. I suspect most of the selling is ETF-driven, accentuated by specific problems with the first quarter that triggered a mechanical response from the computer group. In our brave new investment world, if you "miss numbers" you go down. End of discussion. I reach the ETF conclusion by looking at similar price action in a number of apparel-related retailers, one of which went down in a quarter where EBITD increased $85 million. I believe this is where the single stock fundamental analyst can distinguish himself by buying in the eye of the hurricane.

The Macy's conference call took 1 hour and 20 minutes, with the new CEO being an effective and forceful newcomer. (Macy's calls historically have been handled by the highly competent CFO.) Here are the key points. Keep in mind the earnings shortfall was $10 million. For this shortfall, the stock is down more than $1.2 billion in equity capitalization:

  1. The company started the first quarter with slightly excessive seasonal inventories. A weak and warm February hurt its liquidation, providing unusual and one-time pressure on first-quarter gross margin. Sales improved significantly in March and April, which need to be combined due to the Easter switch. They probably were 1% below the -2% forecast for the year -- hardly the disaster suggested by the stock price.
  2. The gross margin pressure is concentrated in beauty (Ulta Salon (ULTA) ), hardware and housewares (Amazon (AMZN) , etc.), and watches (lower-priced tech watches). These are not going away. However, the company has strategies to mitigate their impact. In beauty, its Blue Mercury stand-alone stores with spa services are comping double digits.
  3. The company will roll out thoroughly tested strategies in shoes and jewelry before the key selling season. These should provide a lift to comps.
  4. The company is intelligently monetizing its real estate. There are two totally different types of assets. One -- and the most interesting -- is the downtown multistory stores. These are either being sold or some of their upper floors are being sold or leased. Transactions in the first quarter resulted in $98 million of revenue and $68 million in gains. The real estate strategy will unfold in the next 12 to 18 months and seems to me to be both thoughtful and correct. The latest transaction was in booming Seattle, where a white elephant downtown store now has upper floors of (probably) tech offices.
  5. The company is at its leverage and interest coverage targets and is in no risk financially. It is buying debt (6.5% yield) and will continue to do so. Most of this will happen in the fourth quarter, but if real estate monetizes, the proceeds will be used to lower debt. Interest declined 14% in 1Q, hardly the sign of a firm in financial difficulty. Cap ex is $900 million before asset sales. The first quarter suggests $700 million is a better number. There is a lot of free cash flow, with EBITD in the $2.6 billion area. Dividends use $450 million or so. Macy's maintained its earnings guidance ($3.50) for the year. The first quarter had an unusually high tax rate (47% effective). For the year, the company expects a 37% rate. Macy's would be a big beneficiary of tax reform, something the market has forgotten at present.
  6. One other look-alike retailer, Kohl's, reported and incremented its cash flow by $85 million. The stock went down hard. Others already have reported or soon will report. While Amazon is a threat, it can be coped with, as Best Buy (BBY) has demonstrated. Macy's has a thriving digital business (first-quarter growth was above 10%) and has sound strategies to both survive and prosper. In last week's conference call, the new CEO was impressive and he used the "secular" word to describe the problems.

The company will sponsor an analyst day on June 8. That could be a positive catalyst. My guess is attendance will exceed 300 investors and analysts.

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