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Macy’s in a muddle: investing defensively in US retail

Despite an improving domestic economy, the US retail industry is under pressure. Changing consumer preferences, falling tourist numbers, unseasonal weather and the rise of fashion e-retailers are among the reasons why US retailers – and department stores in particular – are struggling. We responded to this structural change with a defensive trade involving Macy’s, whose flawed strategy for reviving sales has proved one of the least effective in the sector.

Last November, we assessed how these dynamics are increasingly affecting US retailers and focused on two department stores, Macy’s and JCPenney, in Spectrum, our quarterly newsletter. We concluded that despite similar elements in their respective strategies, such as a focus on private brands and exclusive products, Macy’s should ultimately underperform given specific weaknesses in its plan.

Macy’s November-December trading statement, released in early January, provided evidence of its deterioration while JCPenney, as expected, continues to reduce its debt. JCPenney started 2017 by announcing the sale of one of its buildings for $353m and its intention to use the proceeds to pay down debt, which is positive for its credit profile.

Festive fail: Macy’s soft Christmas trading
Macy’s reported poor November and December trading, with like-for-like sales declining by -2.7%. While this is a sequential improvement compared to the past few quarters, it remains weak – especially considering the anaemic sales of the previous festive period, and falls below the management team’s expectations.

Management indicated that comparable sales in 2016 should reach the low end of the -2.5% to -3.0% guidance provided. It forecasts 2017 like-for-like sales to remain consistent with those in November and December, and downgraded its earnings-per-share expectations for 2016. We continue to be concerned about some of the company’s strategic priorities, such as closing 100 stores (which would undermine its click-and-collect offering) and dedicated heavy-discount sections (which risk cannibalising sales of higher-margin products).

What happened to the debt buyback?
In its Q3 2016 conference call with investors, Macy’s management team described how it aims to use excess cash. After capital expenditure commitments and distributions to shareholders, it opened the door to paying down some of its debt after reviewing the company’s leverage position at the end of the financial year. While this was well-received by investors, we wonder whether it will be revisited in light of the company’s recent performance and profit warning.

Macy’s debt-to-EBITDA is high, at 3.3x compared to its leverage range guidance of 2.5x to 2.8x. Credit ratings agency Moody's assigned a negative outlook to the company last year. On 5 January, Standard & Poor’s reacted to Macy’s performance and placed the company on negative watch, indicating that it could be downgraded in the coming months, with Fitch following suit the next day, designating a negative outlook for the retailer. A reduction in debt would be a positive step, credit-wise, for Macy’s.

Our trade in Macy’s
To express our negative view on the US retail industry, and on Macy’s in particular, we exercised the flexibility inherent in our approach to establish a defensive position through the company's credit-default swaps (CDSs). This was implemented at a low following the announcement of the potential debt buyback. While the November-December trading statement was released after the US market closed on 4 January, spreads on Macy’s CDS instruments had already widened by 25bps to 208bps. We believe they should continue to widen, at least until the company reports its Q4 2016 performance on 21 February and provides more details about the impacts of industry dynamics and how it is using its excess cash.

Expressing our view on Macy’s

macys-chart-4
Source: Bloomberg as at 4 January 2017.

This position features in the Hermes Multi Strategy Credit strategy, which aims to generate absolute returns that capture the majority of the high-yield bond market’s upside with significantly less volatility. It seeks this through a combination of high-conviction, return-seeking investments and defensive trades. For the calendar year 2016, the strategy provided 10.08% gross of fees in US dollar terms, and 6.01% since its 31 May 2013 inception.1

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