Contributed by Dmitrijs Soha, Head of Asset Management at Pinnacle Global Alpha
What are the prospects for omnichannel multi-brand retail? Given current negative sentiment for the retail industry, can a seamless customer shopping experience incorporating bricks-and-mortar, online and mobile be aligned with a competitive undervalued business?
We believe the market clearly underestimates the true potential of Macy’s. We consider this company an example of a grossly underestimated omnichannel turnaround story. A cash flow positive, operationally sound, strong – branded omnichannel multibrand retailer going through swift transformation delivering 7 consecutive quarters of comparable sales growth, all the while priced to no growth and significant top and bottom-line margin deterioration.
Macy’s Financial Summary
Macy’s is a profitable business with a solid balance sheet, relatively high margins, swiftly growing omnichannel presence, great brand, and an in the works transformation plan, all the while priced to a scenario of no growth, loss of market share, and significant margin compression to levels below peer average.
The company operates in a highly competitive industry undergoing major structural change with online swiftly capturing its share of revenues. Virtually all of the company’s peers are steadily growing online presence, introducing new product lines, and rolling out various types of promotions. It is a change-or-die situation and we believe the company is on the right track to returning to growth on decent margins.
The market, however, seems to think otherwise as it prices in a scenario of a decline in revenues coupled with a significant deterioration of margins over the next 6 years and a perpetual decline in revenues of 1% p.a. on margins below peer average, essentially voiding all of the company’s efforts and denying it organic growth with the market which is expected to grow at 2% p.a.
We will show that the company is grossly undervalued even if it keeps its revenues flat while experiencing a significant drop in top line margins and rising SG&A expenses, a double whammy of losing market share and becoming less operationally efficient.
The above is contradictory to the management’s transformation strategy that seems to be making decent progress history, as the gross profit margin had been stable all the way since 1999, and recent progress, as the digital business delivered its 40th consecutive quarter of double-digit growth, and total comparable store sales have been positive over last 7 consecutive quarters.
Albeit it being a much discussed topic, we decided it prudent not to engage in speculation on the market value of the company’s real estate portfolio and to not add it to our valuation model, as we cannot be certain that the proceeds from real estate liquidation will cover the expected discounted cash flows from the corresponding stores.
It is our firm belief that the company has lots of potential in SG&A cost optimization and that alone should be enough to keep its margins stable, making for a healthy annual free cash flow of circa $1 billion, more than enough to send the market a strong message by executing on a $1.7 billion share repurchase program, continuing a double – digit dividend, and possibly retiring a good chunk of debt.
Since there exists an obviously significant negative current market sentiment on the retail industry, the company enjoys an inherent multiplying effect on any positive changes to its operations, making it a potential multibagger.
We believe the stock might be a good long position for a fundamental investor not minding the current negative market sentiment on retail and willing to wait for 3 – 5 years for the company’s development strategy to start making an impact on revenues and margins, increasing its cash flows and turning the overly negative market sentiment. We will try to justify our conservative target price for the long position of circa 24$, a potential of circa 65% profit from the current market price.
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