Income investors usually focus their stock selections on large-cap stocks that offer well-covered dividends. Often, this search leads to the S&P 500, which is the most widely-followed index of large-cap U.S. stocks.
Investors seeking high levels of income tend to focus on stocks offering robust dividend yields.
Macy’s Inc. (M, Financial) is one of the highest-yielding stocks in the S&P 500 and a name we think could offer outsized returns over the next five years.
Company background and recent financial results
Macy’s operates 680 department stores and 190 specialty stores primarily in the U.S. The company has been in existence since 1929. Today, it has a market capitalization of almost $7 billion and generates $25 billion in annual sales.
On May 15, Macy’s released financial results for the first quarter. Revenue decreased 0.7% to $5.5 billion, which was $20 million below what analysts had expected. Earnings per share declined 8.3% year over year to 44 cents, though this beat estimates by 10 cents.
Same-store sales increased 0.7%, topping estimates of 0.3% growth. During the quarter, Macy’s closed several underperforming stores, helping to explain why overall revenues were down while same-store sales improved. Gross margins decreased 80 basis points to 38.2%. E-commerce sales improved by double-digits and mobile sales were the fastest-growing channel during the quarter.
While many would not consider a department store to be recession proof, Macy’s did actually see a 9.3% increase in earnings per share from 2008 to 2009. Over the last 10 years, the retailer's compounded earnings per share grew at a rate of 11.5% annually. Much of that growth took place in the early part of the current decade. Since 2014, earnings per share has actually contracted 1% per year.
We expect Macy’s will earn $3.15 per share for 2019, which would be a decrease of almost 25% from last year. Given the company’s e-commerce growth and the closing of underperforming stores, we anticipate the company can grow earnings per share at a rate of 2.6% annually through 2024.
Growth prospects
As e-commerce has grown in popularity, brick-and-mortar retail stores have faced intense competition from Amazon (AMZN, Financial) and others. With consumers choosing to shop from their computer or mobile phone, physical retail locations have suffered. More than 5,500 stores closed in 2018, with more than 7,000 expected to close in 2019. Macy’s is no different than most other retailer and expects to close nine stores this year.
While the company is reducing its physical store footprint, it is investing in e-commerce and digital channels. The company has made strides in expanding its online presence since early last year. Though this puts it behind other retailers, Macy’s vendor direct program has grown rapidly since inception. Approximately 10% of online sales now come from vendor direct, an impressive accomplishment considering this program is in its infancy. The company expects to add at least 1,000 new vendors to this program during the year.
Mobile sales accounted for more than $1 billion in sales in 2018 and was the company’s fastest-growing sales channel. We expect this total to expand as Macy’s focuses more on e-commerce and digital sales.
Dividend analysis
Macy’s has an uneven dividend history. The company slashed its dividend by 43% from 2008 to 2009. The retailer has paused its dividend twice (2010 and 2018) over the last decade. Even so, the stock does offer a 6.6% yield right now. While the dividend may not grow every year, it is very high. And unlike in 2008, we also feel the dividend is safe.
Macy’s pays a dividend of 37.75 cents currently. This represented 86% of earnings per share in the first quarter. It is an elevated payout ratio, one that might cause investors some concern. Over the longer term, the dividend appears much safer. In 2018, Macy’s earned $4.18 per share while paying out $1.50 in dividends, for a payout ratio of just 36%.
Over the last five years, which have been difficult for the company, Macy’s had an average payout ratio of 37%. Looking at a longer period of time, the company's dividend appears to be well covered by earnings.
Using this year’s expected earnings, the company has a payout ratio of 48%, which is still rather low. Using free cash flow paints a similar picture.
Macy’s generated cash flow from operations of -$38 million and spent $204 million on capital expenditures in the first quarter of fiscal 2019, for a free cash flow of -$242 million. This means dividends were not covered by free cash flow during the most recent quarter. Looking out over a longer-term horizon shows the company’s dividend is much safer than it appears.
The retail chain generated cash flow from operations of $1.735 billion in fiscal 2018 and spent $657 million on capital expenditures for free cash flow of $1.078 billion. During this time period, the company paid $463 million in dividends for a free cash flow payout ratio of 43%. This ratio is slightly above the company’s average over the past five years.
Again, using the long-term picture for free cash flow, Macy’s payout ratio is low. This makes it likely the company will continue to pay a generous dividend going forward.
Valuation and total returns
Macy’s closed the most recent trading session at a price of $22.69. Using our expected earnings of $3.15 per share for the year, the stock has a price-earnings ratio of 7.2. From 2009 through 2018, the average price-earnings ratio was 10.7. Due to challenges in the retail market, we have a 2024 target price-earnings ratio of 9.5. If shares of Macy’s were to grow to reach this multiple by 2024, the valuation would add 5.7% to annual returns over this period of time.
Total returns for Macy’s would consist of the following:
- 2.6% earnings per share growth.
- 6.6% dividend yield.
- 5.7% multiple expansion.
Combined, Macy’s is expected to return 14.9% annually through 2024. The company’s earnings per share growth rate is low, but the yield and potential for multiple expansion make up for that. If our earnings growth estimate proves to be too conservative, then the stock is poised to post even higher returns over the next five years.
Final thoughts
Stocks with high yields often have some issues associated with the underlying company. Macy’s, along with most other retailers, has struggled to adapt to the new way consumers shop. In a short period of time, Macy's focus on e-commerce and digital sales has led to increased sales. This should continue as the company adds vendors to its vendor direct program.
Macy’s did cut its dividend during the last recession and has a history of pausing dividend growth, but the current yield makes the stock one of the highest-yielding in the S&P 500 Index. Investors with a higher risk tolerance could be well rewarded for purchasing shares of Macy’s at the current price.
Disclosure: No positions in any stocks mentioned.
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