November 16, 2015

Doug Kass buys Macy's shares

Shares of Macy's fell more than 13% yesterday and are now down by nearly 40% for the year. The retailer's weak third-quarter results stunned the markets yesterday and weighed down the entire retail sector.

That said, I purchased a small position in Macy's near yesterday's closing price and plan to slowly accumulate more shares in the days ahead. I'm also adding Macy's to my "Best Ideas" list based on what I see as a favorable risk-vs.-reward ratio.

What's my rationale for these contrarian moves?

Well to begin with, someone could buy Macy's out with the company's own dividend providing the majority of the financing costs. Here's the math:

Current yield: 3.55%
Yield grossed up for taxes: 4.80%
Equity capitalization: $12.5 billion
Net finance cost at 9% (assuming 50% premium): $780 million
Current EBITD: $3.6 billion
Current interest: $400,000
Total interest: $1.18 billion
Capital expenditures*: $1.2 billion
Margin of safety: $1 billion or more

Based on the above, it seems logical to assume that Macy's current share price won't persist for long.

Importantly, Macy's management is quite financially sophisticated -- the company's CFO, in particular, is among the best.

Macy's executives (and several activist investors) recognize the value of the large underlying real estate assets that form the company's foundation. 

My guess is that there are three likely outcomes for Macy's. I think the company will either:
    -consider a leveraged buyout, or

    -partner with a third party, or

    -someone will mount a hostile takeover.

The only other alternative would be a sharp rise in Macy's share price, but that seems unlikely given the low valuations and investors' current disdain for retail stocks.

So, I rate the probability of one of the three events above occurring as high as 75%, even before Macy's releases its year-end results in late February 2016.

The only real negative to my thesis is that a number of retail LBOs have been disasters. However, the big risk in previous retail LBOs -- surging inflation in merchandise costs -- isn't a problem right now.

And what makes me confident about my Macy's investment thesis is that the company's business isn't in a freefall. As Jim "El Capitan" Cramer recently noted, U.S. household net worths are improving and jobs and income growth are satisfactory.

Sales to non-U.S. customers (a 1.5% headwind to sales) are also probably seeing close-to-peak relative strength in the U.S. dollar. I don't believe the euro is going to $0.80, nor the yen to 160 to the dollar.

Moreover, Macy's recent sales weakness was accentuated by unusually warm weather that caused poor traffic for cold-weather apparel. But the chain will mark those goods down during the fourth quarter ("when the ducks are flying").

Management also used relatively austere forecasts in its downward guidance this week. So, it's highly likely that given what will be a very promotional holiday period, Macy's sales will come in well above the forecast -2% comp level. It's also probable that while at Macy's, holiday bargain hunters will find their way to some full-priced merchandise.

Another plus: Macy's is currently selling at under 6x trailing 12-month EBITD. So, the return on buying the stock is 16%+, while the current dividend adds another 3.5%.

To me, that means Macy's could be the best buy on a relative basis to other retailers following yesterday's large price drop.

After all, chains that sell stuff consumers buy to eat currently trade at around 10x to 17x EBITD, while "do-it-yourself" stores fetch about 10x to 14x and autos go for 8x to 11x. But chains like Macy's that sell stuff that goes on the body (i.e., apparel) are trading for just 6x to 8x.


As little Susan Walker put it in Miracle on 34th Street: "I believe. I believe. It's silly, but I believe!"



via http://www.thestreet.com/story/13363595/2/doug-kass-why-i-m-buying-macy-s-stock.html

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