I’ve just wrapped up my second four-day work week, and I’ve been pondering all week what to touch on for my third installment in my Furloughed Ideas series. Until at least the end of April and possibly longer, my goal is to take advantage of my shorter work week by writing on portions of my portfolio that I’ve never covered before. Over the first two installments I’ve covered Cisco (CSCO) and CVS (CVS), and this week rather than covering a single name, I am looking at two names I have in retail investments. All of my retail investments are in deeply negative return territory at the moment, and my intent is to share honestly where and how I think comparing Macy’s (M) and J. C. Penney (JCP) can be constructive for thinking broadly about the challenges and opportunities in retail.
For new readers, I should make clear my portfolio of individual stocks is invested for all intents and purposes in a Roth IRA and equals 15% of my total investments. I plan to be ready to retire in about 20 years, and I am investing more with a value mindset. While I consider previous pieces in the series to be relatively on the lower end of the risk spectrum, my thoughts today move towards a considerably higher risk, a risk magnified by the COVID-19 pandemic.
Traditional Retail Feels Dead in the Water
At the time I am starting to compose my thoughts on retail, the major news of the day is a second week of initial jobless claims in the range of 6.5 million, pushing the total figure from three weeks to 17 million claims. Assume for a moment that the majority of these turn out to be relatively short term, say peaking at 25 million and then 75% of the workers are able to return to work after two months, still those sorts of numbers would send a chill down every retailer’s spine. Results will be awful for at least a quarter, and some retailers might not be able to survive the combination of one bad quarter followed by even a mild recession. There is no shortage of opinions on the possible impact of this virus’s long-term implications for retail writ large – from Greg Maloney’s Forbes piece taking the view it will be bad but not the end of retail as we know it that includes a role of brick and mortar, to Haley Peterson’s reporting in Business Insider that some expect 20% to 25% of US retail stores will be closed within 3 years, and plenty of opinions in between. In my view, everyone is speculating, but a few common points of agreement:
- The United States is broadly over-retailed in brick and mortar square footage, and space devoted to retailing is under strain. However, to some extent, such space is being repurposed to other efforts for value creation.
- Some individual retail names have weak balance sheets and probably will succumb to bankruptcy as a direct result of the pandemic, but are not representative of all retail.
- There is not some monolithic group of American shoppers that necessarily make consistent decisions about shopping, but millions of individual Americans with assorted retail preferences that can be affected by price, convenience, brand loyalty, and peer and social behavior.
The general pessimism over retail is quickly seen in the results of the SPDR Retail ETF (XRT), which tells the tale on its own, having dropped more than 35% since the start of the year, before recently bouncing back somewhat.
Investing in Retail Pre-crisis
The bulk of my retail investing happened just over a year ago, in March 2019, well before this crisis came along in the last two months, and my results are definitely worse than the retail index results, but I try to re-evaluate on a regular basis to decide if I want to average down, give up, or stand pat for a while. I’ll start by summarizing when I decided to buy the retail names I did.
I started buying into Macy’s just over a year ago, in March 2019 when its shares were about $24.00. Macy’s is an absolutely iconic American department store, famed for its Manhattan location at Herald Square and Thanksgiving Day parade in New York. This is the only retail name in which I have a full position and in which I have made multiple purchases on the way down. In the highly speculative space, I made a single small purchase of the J. C. Penney securitized debt (KTP) in March 2019 for $8.01. This is very long-term debt (redemption set for the year 2097) that pays out interest twice a year for an annual total per share of $1.91 in interest (the debt was issued at 7.625%, and the shares have a nominal par value of $25.00).
What was I thinking?
My basic thinking at the time of the investments can be summarized in three words, although not all are applicable to all of the above: 1) valuation, 2) dividends and interest, and 3) real estate.
In March 2019, Macy’s was trading at fairly modest to low valuations relative to the broad market.
At a P/E and price to cash flow ratio both around 10 at the time, the valuation seemed fair and maybe slightly pessimistic, but I saw no particular red flags suggesting it was overvalued.
The common argument specific to Macy’s, and one I believed had some merit, is that the underlying value of its real estate functions as a backstop against declining business performance, and this certainly informed my decision to invest. While I won’t rehash the full pros and cons here, but in brief the logic is this: the balance sheet shows a book value of property at $6.6 billion as of 2/1/2020, but the actual market value of just its two or three best locations could easily be equal to the entirety of the book value – Herald Square in New York, Union Square in San Francisco, Marshall Fields in Chicago (already partially sold in 2018). The value of other real estate would conservatively put the true market value of just the property assets at $10 billion, compared to total debt of $4.2 billion (not counting its draw-down of its revolver for $1.5 billion). For reference, Starboard Capital pegged Macy’s real estate holdings to be worth $21 billion in 2016, so my assumption is 50% less). Even factoring in lease obligations of $7 billion, which will be coming down as locations close, there did not seem to be any sense of existential alarm on the horizon.
(image source: visitmacysusa)
For me, the reason above and beyond the real estate was that Macy’s had actually been running a profitable enough retail business, enough so that cash flow from operations in 2018 was $1.7 billion, plenty to cover dividends of $460 million and fund some attempts at growth capex for 2019. When I made my initial decision to purchase, the dividends were yielding over 6%, which seemed sufficient to compensate for the known risks. In addition, Macy’s had been pretty aggressively paying down debt, and seemed to be a stable and viable business taking positive steps to be better positioned to maximize its future returns.
J. C. Penney is an entirely different story. Same industry as Macy’s, but almost the polar opposite in comparing results and balance sheet strength. A year ago, when initiating both positions, my basic thinking at the time can be reduced down to “Macy’s is strong enough I am comfortable to buy common shares, but J. C. Penney requires being higher in the capital stack and get paid more for the greater risk.” As a functioning business, J. C. Penney is trying to manage a total debt load of $3.6 billion (also not counting the draw-down of $1.25 billion on its revolver) that is only 15% less than Macy’s, but doing so on about half the revenue, $11 billion for 2019, and with only $428 in cash generated from operations, about a fourth of Macy’s results. There is not a parallel case for J. C. Penney having the same sort of real estate value backstop; evaluating the actual market value of its $3.5 billion book value is nearly pure speculation; if it came out with market value exactly equal to book value, then its property corresponds tightly to total debt; so if debt gets brought lower than book value, then there might be minimal value remaining in the business itself.
Weighing the Pros and Cons Today
From the vantage point, now, however, the odds are even more extreme. Can J. C. Penney continue to meet its obligations for the next few years? The interest on KTP is paid each year on March 1 and September 1; the total annual payment per share is $1.91, and KTP is trading for $2.04 (close on 4/9/2020), equal to a ~94% yield. Investing now implies you expect to be basically made whole if the next two interest payments are made this September and next March, and it starts getting crazy good returns if it manages to keep paying or recover beyond that.
In some ways, the variables in this investment are easier to sort through than Macy’s – it really boils down to “Do you believe J. C. Penney will be a going concern for the next 18 months or more? Will it succumb completely to the effects of the virus, or will the $1.25 billion in revolver cash be good enough to get over the hump until things start getting restored to something more like normal?” If so, owning the debt could pay off handsomely. This is going to require some fancy footwork in the very near term in order to make a June 2020 payment of $147 million, and ultimately find a way to roll over debt. The good news for J. C. Penney is that it has no debt coming due in 2021 or 2022, but a massive load for 2023, and the June payment this year should be its only redemption for 2020, with other ongoing interest payments due.
(Source: Seeking Alpha)
Macy’s is more complicated, as the suspended dividend makes it much less appealing. Revenue may not have dried up totally for the quarter; it has been previously reported that about 25% of total revenue comes in online orders, so I have hope that the current season will not be a complete zero. In addition, management has stated it intends to selectively continue a real estate strategy for unlocking value. Pre-virus, the company announced plans to close a chunk of under-performing stores over the next three years – about 125 locations out of an existing base around of 550 (not counting separate 50 Bloomingdale’s or 170 Bluemercury locations). The locations slated for closure accounted for about $1.4 billion in revenue in 2019, out of total revenue of $24.5 billion; the move could conceivably increase cash flow from operations given the expenses of keeping those locations open. I don’t know that Bloomingdale’s adds a great deal of value, but I believe the Bluemercury cosmetics/beauty business has been growing solidly, and is a valuable asset. The virus may speed up the schedule of some closures or even conceivably add to the list total. Whether the owned locations can get attractive bids going into a recession isn’t really the point – surely they will mostly be disposed of cheaply, but any disposals should help margins and either reduce debt or redirect cash into growth capex.
Its debt has been recently downgraded, which I find somewhat surprising to happen now, instead of a couple of years ago when the leverage was significantly higher. It is possible that the downgrade will complicate efforts for Macy’s to benefit from the Federal Reserve’s liquidity efforts, but I am confident the real estate portfolio in place is more than equal to the debt. However, news came out over the Easter 2020 weekend that Macy’s was reviewing its financial options with Lazard as well as Kirkland & Ellis LLP, who have a reputation as debt restructuring specialists. In spite of how negative this may look on the surface, even the Reuters report suggests that Macy’s is considered strong enough to handle its debt payments for 2021 and 2022 without restructuring.
I cannot derive a simple conclusion on these retail names, as the pandemic has absolutely thrown a wrench in their businesses. For me personally, I undertook the investments in what I believed was the appropriate risk order for myself, knowing then they were at the higher end of my tolerance and tried to weight them accordingly. However, on Macy’s, in retrospect, I think I can say I got too attached to the real estate thesis as a justification to build a full position too soon on the assumption the dividend was safe in the meantime (which I think it would have been apart from the virus shock). While I don’t kick myself for failing to predict a global virus shutting down retail almost entirely, I would say I am more clear-eyed today that these may both go down in flames. If I were approaching these specific investment possibilities fresh, I would likely come down against them both for now as not suiting my portfolio needs, but I am not necessarily a perma-bear on the whole retail sector. In the meantime, I am opting to just keep what I have, let the situations play themselves out, and most importantly learn and grow from the experience.
Disclosure: I am/we are long KTP, M. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long additional retail names: mall REIT CBL preferred D shares (CBL.PD), Newell Brands (NWL) and Kontoor Brands (KTB).
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