Macy's- Renaissance Through LBO?

(Disclaimer: Excel file attached below the post) 

I recently came across an article about a takeover offer for Macy's- a brand synonymous with retail and a pivotal piece of the American cultural fabric. On Dec 01, Arkhouse Management and Brigade Capital submitted an offer of $21/ share- a premium of 33% over Friday's closing price- to purchase all of the outstanding shares that they do not possess. Proposed per share price, given Macy's roughly 274MM diluted shares outstanding as of the latest 10Q, translates to an offer or equity value of approximately $5.9B. I am a native New Yorker and so I have always been enamored by Macy's corporate headquarter in Herald Square, by its behemoth presence in the consumer staples and retail industry, and lastly, by its 150+ years of history; and so given my fondness, I decided to inspect the possible outcomes of the proposed transaction. I sternly believe that putting things in historic perspective can be of huge help when valuing a company's operations, basic fundamentals, position in the industry and society, and most important of all, its possible future cash flows; so, as a result, I have taken the top down approach where I will look at the retail industry, Macy's historic performance, and finally, whether or not the company has the operational wherewithal to weather an LBO transaction, especially in this environment.     

Retail Industry: Past, Present, and the Future

Past

I am no historian, by any stretch of the imagination, but I believe that retail is as archaic and crucial in human history as all of the ancient civilizations. Bartering and haggling for goods and services can be traced back centuries, albeit in slightly different formats. It wasn't until the late 1800s and the early 1900s that contemporary form of shopping abridged the gap between culture and retail. It is during this time that department stores began to appear in neighborhoods and changed the retail business in its entirety. Many of those retailers offered so much more than just goods and services, they offered an experience, luxury, and entertainment; in some sense, this was also the dawn of shopping malls: mega-centers with all of the time's major retailers. Retailers like Le Bon Marche, Bloomingdales, Saks, Nordstrom, Macy's, JC Penny, and Sears took advantage of ever changing consumer demands and along with offering goods, they also initiated offering services such as reading rooms, art galleries, and in some cases, even concerts; whatever they needed to do to get consumers through the doors.

The industry, as a whole, has gone through ups and downs but, for the most part, maintained its elegance and need in society. Retailers, to remain profitable and relevant, have embraced other channels of revenues along with their prime brick and mortar locations, online shopping, metaverse, same day delivery, and curbside pick ups to name a few. It should come as no surprise that any industry reliant on end consumer has to invest heavily in analytical tools and software to remain ahead of the curve and the changing consumer trends and behaviors. In order to understand the ever changing hierarchy and tumult in this industry, I looked at the share prices of some of the major retailers, going as far back as possible, and the anarchy could not be more vivid.

As shown, retailers have always persevered through rough micro and macro environments, but this is not an industry for faint of hearts. I can not think of another industry that is as reliant on the macro environment and the general health of the economy as the retail industry. Retailers are easily impacted, good or in adverse ways, by general consumer sentiment and the economy. If you look at the share prices you can almost immediately see that the ups are directly corelated with positive sentiment around economy and less competition, and conversely, the downs are directly related to downturns and recessions. Despite their decades of existence, nowhere else in their history have the retailers had to endure what they went through after the emergence of the world wide web, as shown by the decrease in the share prices after 2000s. Internet did to retailers what they did to prior forms of shopping: it made them less relevant. It is come human fallacy to think that the deeper you are rooted in society, the harder it becomes to dismantle you; major retailers suffered from a similar ailment. They thought that they will remain forever green and no disruption of any kind could unwind or alter their existence. 

Turn of the century became the beginning of the end for traditional retail shopping. The emergence and mass adaptation of internet gave customers what they always deeply desired: the convenience and capability to shop from the comfort of their homes, and companies like Google, Yahoo (a major player back then), and Amazon were more than happy to oblige. I believe that traditional retailers could not fathom a society without their trademark store fronts and locations, and so they lagged in terms of keeping track of their competition, namely Amazon, or even invest in similar technologies and advancements so that they could at the very least retain their customer base and market share. Driven by their hubris and egotistical ways of doing business, they became more and more irrelevant with every passing year.   

Present

Even before the COVID-19 pandemic, many of the major retailers were on the brink of collapse given the heavy load of debt and liabilities and higher costs of doing business compared to their dwindling revenues and operating incomes. To make matters worse, health related closures during the pandemic wreaked havoc across the spectrum and retail industry was pummeled the most. With zero foot traffic and heavy load of lease and debt liabilities, many of the major retailers have had to file for either chapter 11 or 7 bankruptcy. J.C. Penny, Neiman Marcus, Sears, GNC, J. Crew Group are some of the notable names in the long and ever expanding list of bankruptcies in the retail world. 

Some of the bankruptcies were driven by lack of innovation or just flawed business models for the modern days, while others were pushed into oblivion due to a number of industry trends being accelerated by the pandemic. Digital commerce is not a new norm, as mentioned before, it has been around for nearly two decades now, but pandemic made shopping online a necessity and so the retailers had to adapt, those who could, lived for another day, and those who couldn't, became part of the bankruptcy statistics. Another trend that skyrocketed during the pandemic was working from home and little to no social life; which essentially meant that consumers had less incentive to go out and shop for work or social soirees. I am a 'cup half full' kind of a guy and so I try to see the silver lining in everything; the good thing about pandemic is that it has given us an emphatic understanding of the symbiotic relationship between consumers and the retail industry. 

Future

It is not all doom and gloom in the retail world. Retailers are convalescing and will emerge from the dust with a far better understanding and resiliency. Fluctuations, pre and post pandemic, have compelled retail executives and managers to think out of the box, to conjure creative solutions to their modern problems, and most important of all, how to survive given the current competitive climate. Going into the future, retailers will have to assess what matters to their consumers the most, and how to best deliver that at the lowest possible cost. To that end, retailers- both major and regional- will need to take initiatives to invest in their supply chains, digital commerce, and omnichannel capabilities. Executives and managers will need to understand that customers are tethered to a seamless and convenient experience. Digital presence will also play an integral role in determining who survives and who essentially will lose their business. Retailers will have to invest ever more in software development, online platforms, and better analytical tools. The cost of acquiring a customer has skyrocketed compared to a few years ago and the cost of retention is even higher, and so investing in modernized ways of shopping could serve as an anchor that reinforces customer loyalty. 

Given retail world's dependence on the macro/micro environment, there are some economic trends that I believe retailers will have to keep an eye on and possibly even endeavor to mitigate. A slowing economy could push sales further down and rising rates and inflation could inflate the cost of doing business, and so managers will have to keep their COGS, SG&A and R&D in check for the next couple of years. However, the stunted growth due to a slowing economy could partially be offset by a relatively strong and resilient labor market. With the soft landing narrative winning the democratic race, I believe that consumers will continue to spend. Additionally, with things returning to normalcy- social events and soirees- consumers will be tempted to again experience the traditional ways of shopping by physically going into the brick and mortar stores and malls rather than shop entirely online, think Hudson Yards in NY or Newport Mall in Jersey City. 

Secondly, inflation could play a huge role in this space for the next couple of years. Flashy rate hikes over the last year and half has given rise to inflation which has reduced consumers' purchasing power. Retailers will see their nominal earnings grow due to inflation, but it is the real sales that they will have to keep an eye on. Finally, consumer spending on services is likely to continue into the near future. Pandemic was all bad, but people spending essentially a year and a half indoors could prove to be the oasis that retailers needed. Most people are agitated and are desperate to make up for the time that they have lost, and so they have come back- events, concerts, and parties- with a thudding bang. This increase in spending in the services industry could also trickle into the retail industry. 

Macy's

History

In 1858, R.H. Macy opened a dry goods store in New York City and called it R.H. Macy & Co. It eventually grew into a phenomenon and rapidly began expanding and taking over adjacent buildings. Macy's is credited for having created the modern department store along with other major breakthroughs in the retail industry, namely to include buying and selling of products using cash, introducing products such as the teabag and Idaho baked potato, and also creating a made-to-measure clothing operation that tailored suits and clothes onsite. Macy's is also highly tooted for their elaborate and festive window dressings that the department store started way back in 1864 along with concocting the retail Santa concept. After R.H. Macy's demise in 1877, the Strauss family took ownership and in 1902 moved the department store to its now iconic location in Herald Square. Macy's held it inaugural Thanksgiving Day Parade in 1924, a tradition that has not only survived to the present day but has also increased the brand's value exponentially. As of the FYE 2022, company owned 722 locations and 783 boxes. 

Macy's, for years, has been analogous with retail shopping and department store model. Consumers have been visiting Macy's stores to purchase everything from clothes and cosmetics to perfumes and furnishings for years, but its elongated history also means that it has suffered from every minor and major event in the economy along with the corresponding ailments of the retail industry. So, as an effort to offset some of the downsides of the business, Macy's sought to grow through partnerships and acquisitions; and has acquired brands such as Bloomingdales, and Bluemercury along with having inhouse innovations, i.e., FDS Bank, Market by Macy's, and Macy's Backstage along with many others. To understand how Macy's has prevailed over the years, I looked at its share price and trading volume since its IPO, that is a long way back but I believe the image below provides a better view of the past and the future to come for Arkhouse and Brigade.

One thing that is immediately evident is that the stock has not seen stability ever since it went public. It witnessed gradual growth from 1992 to 2000, and around the emergence of internet, it became volatile with periods of highs and lows through time. Another thing that might be noticeable is the fact that the lows are directly correlated with economic recessions. The first slump came in the 1999-2000 period and if you are as old as I am, you'd know that that was the dot-com bubble. For years after 2000, it showed growth and prospects but then plummeted during the great recession from almost $50 a share in 2007 to $10/share by early 2009. Final thoughts on Macy's performance throughout the years is that it is nearly impossible to predict what the future holds for this particular industry; I wouldn't even care to venture a guess as to its long term growth let alone the potential possibilities that could change its trajectory in the future. Macy's is not alone in this arena of instability and volatility though, from what I have gathered, it comes with the territory. Below, I look at some of the major players in this sector and their market capitalizations over the course of the last five years. 

As I said before, equities in this particular industry are not for your IRAs or 401Ks, but they do seem like the ideal candidates for options and derivatives players in the marketplace. I am utilizing the six stocks in the graph as proxy for the sector as a whole, but the above image only traces the market caps for the last 5 years, imagine what it would look like if we went back 10 years, 15 years, or maybe even 20 years. The unpredictability is resounding, and I think that going into the future, we have to keep the past in our rearview mirror before we make any prophetic projections. 

Business

Macy's divides its net sales into four categories: Women's accessories, shoes, cosmetics and fragrances, Women's apparel, Men's and kid's, and Home/other. Company's also gets a decent portion of its total revenues from its credit card business. According to the latest 10K filed in Feb 2023, Net sales for women's accessories, shoes, cosmetics, and fragrances were $9.5B; $5.3B for the women's apparel; $5.2B for the men's and kid's, and lastly, 4.2B for the home/other category. Net sales for all of the categories combined was $24.4B in FYE 2023, a slight decline of (1%) YOY. Company also reported $863MM in credit card revenues, and given their COGS and SG&A of $15.3B and $8.3B respectively, yielded an operating income of $1.7B and margins of 7%; you can immediately see the flaws in the retail business model. To put things in historic perspective, I also looked at Macy's net sales, excluding credit card revenues, for the last 20 years along with its operating income and margins.

Macy's operating margins have never seen a pretty day. Cost of doing business and SG&A have weighed on billions of revenues throughout its observed operational history. Knowing how the PE industry and LBOs generally work, this could potentially be one of the drivers for future improvement of cash flows and therefore payment of future leverage to boost IRR and MOIC for investors at exit. 

LBO 

Macy's has historically been slow to adapt to new technologies- one of the slew of reasons of fluctuations in its stock- such as online shopping or modernizing its store fronts. Macy's has made herculean efforts- new brands, smaller stores, and improving its online presence- over the years to revitalize its brand and improve its long term trajectory. Macy's stock has dropped more than 70% from its once peak of $73/share in 2015 to $15.76/ share as of the writing of this post; making it a prime target for a consortium of PE firms. Macy's generates plenty of operating cash flows, enough to even finance this proposed transaction under my personal hypothetical assumptions pertaining to debt and interest rates; the question that I asked myself at the end of this analysis is "why hasn't anyone taken Macy's private over the course of last 10 years?" The company has the potential to trade at $73/ share, and given that it has been trading in the teens for a good while now, with healthy revenues and decent operating income, where have the PE firms been? As I run through the numbers, I don't think that this LBO would be difficult, even in this environment. In the long run, the investors could greatly benefit from the company's intangible assets, as well as from potentially liquidating its prime real estate locations- Herald and Union Square- to even selling off the credit card business and other subsidiaries such as Bluemercury and Bloomingdales. As of the writing of this post, the terms of the deals were not disclosed other than just the offer price, and so I have made some high level assumptions in terms of what the enterprise value could be and what amount and kind of debt the company could think of undertaking. 

As disclosed, the investors made an offer of $21/ share, a 32% premium over the last Friday's closing price, for Macy's roughly 274MM (according to 3rd quarter 10Q) diluted shares outstanding. The proposed share price gives us an offer value of $5.9B, and with Macy's net debt of $5.8B, an enterprise value of roughly $11.7B. I have also assumed that the group decides to keep a minimum cash balance of 200MM through the holding period, as well as assuming that the exit multiple will be the same as the entry multiple: 5.8x. Some other assumptions that I have made are about the kind of debt the investors could take on and the potential interest expense on that debt. I have assumed that the consortium will take out a revolver, but the revolver will have a balance of zero at the beginning (for simplicity, I have not tethered revolver's drawdown to inventory or other assets), along with term loans. I have also assumed that the transaction and financing fees will be $118MM (2% of offer value) and $741MM, respectively. Additionally, I have made the following assumptions for the sources and uses of funds for this transaction.

Cash Flows

Macy's has plenty of adjustments that we need to make to make sure that we arrive at an appropriate adjusted EBITDA and operating cash flows. For FYE '22 and '23, starting from net income, after adding back interest expense, taxes, stock based compensation, depreciation and amortization, and other non-recurring charges, the company's operating cash flows were $1.6B and $2.7B, respectively; we also get $3.3B and $2.1B in adjusted EBITDA (for both the years) after making the necessary adjustments- I decided to arrive at normalized EBITDA through NI as opposed to the conventional way of working down from EBIT because that is how the company goes from GAAP to Non-GAAP in its financial statements and I wanted to stay consistent with that.  

At the time of this analysis, SOFR was at 5.32% and so I decided on a 2% spread over SOFR for the revolver and term loans A and B, as well as assuming 7% for both the senior and subordinated notes, and given the total amounts shown above, the interest expense would be $841MM in the first year, $783MM in the second, and $685MM, $552MM, and $391MM for the last three years. I have also made the implicit assumption that the terms of the loans also require 6% annual amortization for both the term loans, giving us annual required loan payments of 507MM for the holding period. Additionally I have assumed 100% cash sweeps (unconventional, I know, but I wanted to test the limits) for both the loans. After having put all those numbers in, and letting excel do the work for me, even my base case generates enough healthy cash flows to pay the annual interest expense along with the required paydowns. My base case assumptions also show me that any drawn revolver in the first year, along with $5.3B of term loan A and a significant portion of term loan B could all be paid off by the end of the fifth year, leaving senior note of  $3.3B and $1.4B of term loan B at exit. I have intentionally left preferred stock and management rollover blank, but they are all tethered so any curious Joe could give those tiers of the capital structure a shot and see what the model spits out. 

Returns Analysis

In my base case, the acquired company could have $5.3B in adjusted EBITDA on total revenues of $27.7B in the exit year. Given the same entry and exit multiple of 5.3x, we get an enterprise value of $29.8B, and with a net debt of  $4.6B, we get an equity value of $25.3B at exit, a mind-boggling 90% IRR and 25x MOIC. If we assume that the investors could sell at a higher EBITDA multiple, say 6.6, they would have $30.6B in equity, an IRR of 98% and MOIC of 30.3x. So, I ask again, why hasn't this happened before? I am unaware of the investors required rate of return so I wanted to see what the maximum amount of offer value could be at various hurdle rates, and the results are as follows:

As is evident by the matrix above, if there hurdle rate, rate of return, was 20%, the maximum offer they could make is $15B to reach that hurdle rate. And if there required rate of return is 30% or 35%, the maximum they could offer is $11.7B and $10.5B, respectively. If the investors can get away with an offer value of $5.8B, it would be an early Christmas gift for them. I do not see, under any scenario, $5.8B being a fair value for Macy's and its operations. The company has real estate holdings that could very well be worth anywhere north of $4B, and highly lucrative intangible assets and other businesses that could be used to either finance the transaction or liquidated to pay the debt down the road. 

Conclusion

The purpose of this analysis was twofold, one to satisfy my own curiosity, and second for educational purposes. But some parting advice for Macy's BOD, ask for more, way more!

Links:

Macy's LBO Valuation