Source: Fortune

Traditional retailers have been facing headwinds for a while. Some have to choose between culling underperforming stores, cutting headcount, and selling real estate in order to stay afloat. S&P recently downgraded Macy’s (M) to junk status, which could accelerate the company’s restructuring plans:

Pressure is mounting on Macy’s to adapt to the rapidly changing retail environment,” S&P said. “Its Polaris strategy, which includes meaningful restructuring and renewed focus on loyalty programs, private labels, and e-commerce, will be a challenge to implement successfully amid increasing competition from retailers that are ahead in many of these areas.”

The credit-rating company was referring to a new three-year strategy that includes eliminating 2,000 jobs and closing 125 stores — or almost a quarter of its total locations. Macy’s said those stores account for about $1.4 billion in annual sales. The department store chain also said with its plan, it expects its annual gross cost savings to be $1.5 billion by the end of 2022.

Shoppers are shifting preferences from mall-based retailers to more value-oriented brands like Burlington Stores (BURL) and TJ Maxx (TJX). More retail sales are switching to online as well. For the month of January, retail sales through department stores fell 4% Y/Y, yet rose double digits through non-store retailers. This implies fewer customers are shopping at physical locations owned by Macy’s.

S&P Views The Company’s Competitive Position As Unfavorable

A rationale for the ratings downgrade is that S&P views the company’s competitive position as unfavorable. Macy’s, recently, announced it was closing 125 stores and axing 2,000 corporate staff in an effort to rightsize the company. The company will also consolidate its headquarters by closing certain sites in Cincinnati and San Francisco. Some of the company’s stores are located in Class B and C malls were sales are falling faster than others. The sooner Macy’s can exit these locations, the better.

In the meantime, the company’s performance is eroding. Revenue for its most-recent quarter was $5.6 billion, down 4% Y/Y. Gross margin ticked down 30 basis points versus the year-earlier period. SG&A expense fell 2% Y/Y, much less than the decline in revenue. As a result, EBITDA fell Y/Y by double-digits. It could fall further while management culls its weaker-performing stores.

The company’s weakening profitability was likely another factor in the downgrade. Macy’s generated last 12 months (“LTM”) EBITDA of $2.9 billion. Its $4.6 billion debt load is now at 1.6x EBITDA. Its debt appears manageable for now. However, if EBITDA continues to slide, then so will the company’s credit quality. S&P is likely assuming the continued slide in EBITDA will cause a rapid deterioration in credit quality, causing the rating agency to be preemptive in downgrading the debt to junk status. In my opinion, the move the highly-unusual. The rating agencies tend to wait until a company’s debt is at or slightly above junk status before downgrading it further. The ratings actions could portend the expectation that the next few quarters could be ugly for Macy’s.

Macy’s Needs To Prove It Can Pare Debt

Macy’s has cash of $301 million, down from $736 million in the year-earlier period. Working capital of $1.8 billion is ample. However, it includes $7.3 billion of inventory build-up during the holiday season. The company must sell down this inventory quickly and convert it to cash in order to pare debt. Management must pare debt at quickly as possible to help buffer the diminution in EBITDA and pending deterioration of its credit metrics.

Macy

That said, Macy’s must prove it can become cash flow positive. Through the first 39 weeks of the year, the company had free cash flow (“FCF”) of -$640 million, down from -$248 million in the year-earlier period. For the 39 weeks ended November 2, 2019, the company generated cash flow from operations of $172 million. Capital layouts for PP&E and capitalized software were over $800 million.

Macy’s must continue to innovate and perfect its digital platform in order to keep pace with Amazon (AMZN), Target (TGT), and Walmart (WMT) who have deeper pockets. That implies it could be extremely difficult to cut capital expenditures and maintain online sales at the same time. A large part of its earnings and cash flow is generated during the holiday season. That said, its next earnings report will reflect cash flow after the holidays and for the full year. If it reports negative FCF for the full year, then that could be a red flag.

Going forward, the company must rein in capital expenditures in order to generate positive FCF. It must also rapidly pare debt to prove to the rating agencies it can service debt from existing FCF and does not have to resort to selling real estate. If Macy’s cannot generate positive FCF, then it could call into question whether its cost structure or business model is sustainable. Macy’s could be running out of time to prove it can compete in a world where sales through physical locations continue to shrink.

Conclusion

The ratings downgrade could amplify debt costs and limit the company’s ability to raise capital. If Macy’s cannot prove it can prove debt from existing cash flow, then more downgrades could be on the horizon. Sell M.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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2020-02-21