David Einhorn (Trades, Portfolio) has also jumped on the Macy's (M, Financial) express along with fellow activist Starboard Value. The guru, who had a terrible 2015, is looking for some redemption, and the Macy's thesis makes a lot of sense.
Retail, as a whole, is currently out of favor. Many firms are struggling, distressed or already bankrupt. Macy's is doing much better by comparison but isn't exactly knocking the ball out of the park, either, and its share price has suffered:
Einhorn likely took notice of Starboard's activist campaign and how Macy's share price recently fell apart. With Macy's now trading at $38, the thesis makes a lot of sense to him (his comments are from his shareholder letter):
We established a position in Macy’s, the operator of about 900 Macy’s, Bloomingdale’s and Bluemercury stores, at an average price of $45.69. Earlier in 2015, with the stock at $70, an activist argued that the store real estate could be separated to unleash a valuation in excess of $125 per share. Management determined a whole-company REIT wouldn’t provide the required operational flexibility. Now, with the stock closing the year at $34.98, the math might make more sense.
What's the deal with this REIT structure? Macy's has an incredibly valuable real estate portfolio that houses its stores and distribution centers. Starboard Value estimated the value of the portfolio at $21 billion. With Herald Square's value estimated at nearly $4 billion, it adds up:
Interestingly enough Macy's entire enterprise value equals just $19 billion. If these assets are spun off into a REIT-like structure, that increases their value. Although the net economic effect would be zero to Macy's, the REIT structure turns it into a value-creating transaction. Inside Macy's earnings are taxed at the standard corporate rate, but inside a REIT that rate goes down tremendously.
Management has said it doesn't want to spin off its real estate, but Starboard Value is trying to convince it to look into the benefits of a similar but less transformational transaction. See my recent article on Starboard's letter to Macy's.
Einhorn isn't waiting for Starboard although he has his own ideas about what could happen to the illustrous retailer:
While it’s unlikely that management will reverse course on its own, it wouldn’t surprise us if a private equity firm teamed up with a REIT to buy the company and unlock the value privately.
Currently the gap between Macy's real estate value and its enterprise value is large enough for this to be a feasible path. Because the PE/REIT syndicate would need to offer a substantial premium (think in the 30% to 40% range), a move like that becomes unfeasible if shares run up too much. I would guess that near $54 per share this scenario becomes much more unlikely, and it will decrease exponentially from that point on.
Even if this doesn’t happen, the shares are cheap at 5x EBITDA, 7x equity free cash flow and less than 9x 2015 EPS with a healthy balance sheet and strong history of share repurchases. We think a portion of the recent sales weakness was driven by unseasonably warm weather and a strong dollar impacting tourist business, which should set up for favorable comparisons in 2016.
Einhorn cites the EV/EBITDA multiple, the 7x cash flow multiple and the 9x earnings multiple, all of which are really low. Especially if you consider Standard & Poor's 500 averages of 19x earnings and 11.5x free cash flow. There isn't a lot of cash on the balance sheet, but the debt of about $8 billion is only 2x EBITDA. And then there is the $20 billion in real estate. You can call that a healthy balance sheet. Finally, Macy's may have suffered from the warm weather as it is traditionally strong in selling expensive winter coats.
The dollar may have impacted the tourist business. Both are as unpredictable as can be, but at least the weather is likely to show a reversal to the mean over 2016. We will know by next January or possibly sooner if a private equity firm takes up the gauntlet.
