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A surprise cut to junk

| February 21, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

S&P recently cut Macy’s (M) rating one notch to junk (BB+ with a stable outlook), slightly surprising markets. The downgrade reflected its view that M’s improvements are weaker than expected. The agency further remarked that while Macy’s newly unveiled Polaris strategic plan is necessary to rightsizing the business, execution risks remains elevated. Since Macy’s ratings from Moody’s and Fitch are still at the low BBB level roughly $2 billion of Macy’s bonds will remain in the IG Index, which could provide some support for spreads.

We were surprised by the cut as we do believe M has done a considerable job in reducing leverage. Management has been using asset sale and free cash flow proceeds to chip away at debt levels helping to bring adjusted leverage closer to its target range of 2.5x-2.8x. Adjusted leverage including asset sale gains was 2.9x at FYE19 (3.0x excluding the gains), after repaying $565m of debt this year. While M continues to pay a dividend, share repurchases have remained on hold, despite the stock being close to a 52 week low at $16.25.  Furthermore, debt reduction has outpaced the dividend payment for the past three years, underscoring management’s commitment to bringing leverage within its target range.

S&P’s stable outlook reflects its view that cost saving initiatives associated with the Polaris plan should offset expected sales declines. S&P also believes that leverage is likely to be maintained at 3.0x or lower over the following year as they expect M to continue to reduce debt. Additionally, S&P noted that they could consider raising M’s rating should the company stabilize sales performance and improve margins while keeping leverage below 3.0x. Historically, adjusted leverage of 3.5x or greater has long been the threshold for a downgrade to junk for a retailer. (Moody’s threshold from its last publication is 3.75x while Fitch’s is 3.5x). Given that leverage is currently at 2.9x and is expected to be maintained at or below that level as M works through its “transition year” underscores the surprise in the downgrade.

Target Leverage Ratio By 2022

M dedicated a couple of slides at its analyst day discussing its capital structure and its commitment to hitting its leverage target over the next three years. M guided to cumulative free cash flow of $1.9-to-$2.3 billion over the next three years. Additionally they plan to monetize approximately $700 million of assets over the same time period.  That said, M plans to reduce net debt in the $0.7-to-$1.0 billion range by 2022. This could be done without a tender as M has just shy of $1 billion of debt maturing over the same time period. Based on management’s target of adjusted EBITDA in the $2.2-to-$2.4 billion range in 2022, coupled with the aforementioned debt reduction, estimates are that leverage can fall to the 2.4x-2.7x range. Lastly, M believes it will have an additional $0.2 billion to $0.8 billion of excess cash, after dividends of $1.4 billion, that can be used for new strategic initiatives or to resume its share repurchase program. Management emphasized they would not resume share repurchases until they have achieved their leverage target.

Exhibit 1. M Cash Flow Breakdown (Cumulative 2020 through 2022)

Source: M Analyst Day Presentation

M Bonds Remain in IG Index  

While it is anyone’s guess whether Moody’s or Fitch will follow suit, they both currently have stable outlooks on their ratings. S&P was the one agency to waffle back and forth with its outlook revising it to stable in April 2019 and back to negative in November 2019. Despite the downgrade by S&P, Macy’s other ratings are still at the low BBB level, so its roughly $2 billion of eligible bonds will remain in the IG Index. That could provide some support for spreads of its index eligible bonds.

Exhibit 2: Historical spread comparison (M 2.875% vs LB 5.625% 2023)

Source: Bloomberg

2023 Bonds Look Interesting

Previously M has been compared to its department store peer Kohls, with a split rating, a better comp is likely L Brands (LB – Ba2(*-)/BB-), particularly as M’s spread levels are more indicative of a HY credit.  LB has long managed leverage to the 3.5x area (currently 3.4x) and that is not expected to change much even with the sale of Victoria’s Secret and proceeds going to debt reduction. LB will be reducing debt by roughly $1.0 billion with sale proceeds and cash on hand, which can easily be achieved by executing a MW on the 2021 bonds while doing a partial tender for the 2022 bonds. For the past year, the mean relationship between M 2.875% 2/15/23 bonds has been roughly 85 bp through LB 5.625% 10/15/23 bonds. With M’s downgrade, the relationship in the 2023 bonds between the two credits has reversed. A swap out of LB and into M in this part of the curve provides for a pick of 3 bp (g-spread) while taking out nearly 10 points and shortening 8 months.  Furthermore, M’s 5-year CDS currently trades nearly 30 bp through LB’s 5-year CDS.

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