Macys digital comeback vs Coty debt fuelled decline

The irony of a stock from one of the most beaten-down sectors leading one of the U.S. stock market’s best days for weeks apparently wasn’t lost on traders on Tuesday.

Clicks and mortar

Macy’s, the $6bn U.S. department store institution that has struggled for the last two years alongside bricks and mortar rivals under increasing online competition—AKA Amazon—announced a revamp that will merge three divisions, merchandising, planning and brands, into one.  It also said it had hired a new executive president from EBay, noting his “deep expertise at the intersection of retail and technology, a diverse set of business experiences that give him a unique perspective, and a track record of successfully driving a change agenda at scale”. The restructuring, which will have a one-off cost of about $20m-$25m aims to save $30m annually. Momentum, which lifted the stock as much as 5% on Tuesday after a 55% 9-month decline, was also fuelled by the stock’s undemanding valuation. At 5 times the current year’s forecast earnings, Macy’s price/earnings is less than half that of close rivals. At c.9 times on a trailing basis, it is again less than half the S&P’s, which is currently just below 22 times. That’s despite the group generating some $1bn in annual free cash flow and possessing a real estate portfolio with a book value in 2016 of $20bn.

Heavy Coty

The consumer theme on the market’s best day for over a week didn’t end there. Another high-profile customer-facing name, Coty was lodged at the other end of the market. Coty traded almost 18% lower at one point after the beauty product maker reported a surprise Q4 loss. It cited higher spending on marketing and costs from buying Proctor & Gamble’s beauty unit. It also warned that retailers would probably reduce stock of P&G beauty products until 2H 2018. It said it was actively working to address its fixed cost base—up to 53.1% in Q4 from 46.6% in the year-ago quarter.

Whilst it has underperformed the S&P 500 personal products index by more than 20 percentage points this year, Coty also has patches of unappreciated value. Gross margins have been stable around 60% since 2010; revenue was turbo-charged by the P&G business buy, whilst free cash flow generation has been growing each year since 2013, coming in just below $400m at the end of its last full year. The cost of that growth has been high though. Leverage rose sharply to pay for the P&G unit and margins have declined alarmingly over the last two financial years. Nor is the stock as much of a ‘bargain’ among rival shares as Macy’s. Coty shares cost just 1.05 times less current full-year earnings than the average of the S&P 500 personal products sector. That implies there are almost certainly better value propositions in its sector.

All told, striking divergence between Coty and Macy shares on an apparent turnaround day for the U.S. stock market suggests they might make a good pair for the medium term. We would see Coty as likelier to continue declining over that horizon than Macy’s.

Below we plot the Macy's/Coty spread (sub-chart) since Coty’s first public trading day on 14th June 2013.

• The spread broke definitively below its long-term channel of 1 standard deviation in April, having flirted with the lower boundary since late 2015
• If we’re right, the spread should trend higher and back within the channel into the year end, representing the outperformance of Macy’s
• The ratio level of 5 may be a useful marker for the next few weeks, compared to 3.25 at the time of writing. Successfully passing it would affirm our bull case for Macy’s and the converse for Coty
• Should the spread fail to make satisfactory progress over the near-to-medium term it would tend to invalidate a pair strategy, though our preference fundamentally would continue to be Macy’s

WEEKLY CHART: MACY'S VS. COTY, MACY'S/COTY SPREAD

Source: Thomson Reuters and City Index