FA Alpha Daily

Betting on restructuring is a dangerous game

Businesses like Macy’s are in decline as they struggle to adapt to market changes, such as the shift to e-commerce, resulting in large losses and store closures. Despite being pursued for a takeover by investment companies, Macy’s turned down a $5.8 billion offer, leaving it with the option of finding a better deal or attempting an unlikely successful self-restructuring. In today’s FA Alpha Daily, let’s revisit Macy’s to explore restructuring options that might change its course following a period of decline.

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Once businesses start to decline, achieving a return on assets that outweighs their cost of capital is difficult. Companies must start to adjust key parts of their operations.

Whether it be management or financing changes, a company needs to adjust something significant to survive.

And we can see this, especially with department stores. The market size of the industry has been declining 4.1% y-o-y.

People are migrating away from department stores, and the rise of e-commerce players has only exacerbated this. The majority of items that used to be bought in stores can just be sourced online, usually for the same or cheaper prices.

Yet Macy’s has been inefficient in adapting to e-commerce and changing customer preferences.

Its stock was $73 per share in 2015… and now it’s just around $18. Macy’s had to close nearly 300 stores and lost $3 billion in annual sales. There have been signs of Macy’s heading to bankruptcy just like its fellow brick-and-mortars: JCPenney, Sears, and Lord and Taylor.

However, when a business has shown obvious signs of decline like Macy’s, it becomes a potential takeover target for investment firms who see value. Two investment firms, Arkhouse Management and Brigade Capital Management, offered to buy Macy’s at $21 per share.

Since the offer is for a premium, it’s clear they see Macy’s as undervalued in the public markets. A takeover like this may result in a restructuring of the underlying foundations. And Macy’s could be one of those businesses that boasts a comeback in the market.

However, Macy’s decided to decline the $5.8 billion takeover offer. Instead, it’ll either hold out for a better deal, or it’ll try to restructure by itself. The issue is, that’s unlikely to get it anywhere. Most companies that enter the restructuring phase of the lifecycle never make it past restructuring.

Most end up with Uniform ROA right around the cost of capital.

And for Macy’s it seems like the market understands that story. The market expects Macy’s Uniform ROA to fall to just below 5%, which is right around the cost of capital levels. Just take a look here…

As we have seen in startups, it isn’t easy for a business that is dying out to see a return to profitability beyond the cost of capital that is reflected in the market. The failure rate for businesses looking to make this change is nearly 50-70%.

It is possible that instead of assuming upside, these types of businesses’ current valuation may be too high when planning to restructure. They should be selling at a discount to book value instead.

Investors must stay wary of how the market feels. Sentiment for restructuring is usually more positive than it really should be.

Rather, looking for a value in business with potential that the market isn’t realizing may be a better bet for investors.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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