Fitch Downgrades Macy's (M) IDR to 'BBB'; Reflects Lack of Visibility

Fitch Ratings has downgraded the long-term Issuer Default Rating (IDR) on Macy's, Inc. (NYSE: M) (Macy's) and Macy's Retail Holdings, Inc. (MRHI) to 'BBB' from 'BBB+' and affirmed the short-term IDR at 'F2'. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release.

The downgrade reflects the lack of visibility into a sales acceleration that would meaningfully improve profitability after a 14% EBITDA decline in 2015 and Fitch projects a 5% decline in 2016. Fitch expects the recent weakness in the mid-market apparel sector and online migration of sales will continue, limiting Macy's comp growth to flat to positive 1% over the next two to three years, with lower margined online sales essentially offsetting declines to in-store sales.

As a result, leverage is expected to remain elevated in the high 2x range (compared to the 2.2x-2.3x range maintained between 2012 and 2014) on operational weakness and Fitch's expectations that Macy's will divert FCF towards share buybacks instead of debt pay down to maintain a healthy level of shareholder returns. Macy's is exploring various real estate opportunities to enhance shareholder returns, and Fitch believes that any change to Macy's capital structure will be credit neutral at best.

KEY RATING DRIVERS

CONTINUED MID-MARKET APPAREL WEAKNESS

Macy's comparable store sales trends decelerated over the course of 2015 from negative 0.1% in the first quarter (1Q) to negative 4.3% in 4Q. While the second half (2H) was admittedly impacted by weak sell-through of seasonal merchandise due to persistently warm weather, Fitch expects the general malaise in apparel sales, particularly in the mid-tier space, and decline in international tourist traffic to persist in 2016. Mid-market apparel sales have been weak due to a number of factors, including lack of compelling fashion trends and share loss to lower-priced competitors such as fast-fashion and off-price players. In-store apparel sales have been further pressured by share migration online.

Fitch expects Macy's comps to be in the negative 1% to negative 1.5% range in 2016 and improve to the positive 1% range in 2017. This assumes that ecommerce sales, which Fitch estimates at 15% of total revenue grow in the 10% to 15% range and contribute 150 bps to 300 bps to overall comp growth while in store levels are expected to decline 1%-2%. Looking at the overall domestic apparel, accessories, and home-related categories, Macy's would have to generate top-line growth of 2% or above to prevent share loss to other channels such as specialty, discount, and online.

EBITDA EXPECTED TO BE IN THE $3.2B-$3.3B RANGE

Macy's is proactively taking steps to rightsize its cost structure and has identified $400 million in SG&A expense reduction in 2016 which is expected to offset its investments, particularly in omni-channel capabilities at Macy's and Bloomingdale's.

However, EBITDA, which was down 14% in 2015 to $3.5 billion, is expected to be down 5% in 2016 on our 1% to 1.5% comp decline expectation and as Macy's continues to invest in its omni-channel strategy and the long-term health of the business. Fitch expects EBITDA could remain range bound in the $3.2 billion to $3.3 billion range over the next two to three years.

Longer-term, Fitch still views Macy's as well positioned in the mid-tier department store space as it continues to benefit from its My Macy's localization initiatives, invests in its omni-channel and other growth initiatives, and rationalizes its store footprint.

Monetization of Real Estate

The company continues to pursue the creation of shareholder value through real estate initiatives. Macy's has recently added real estate expertise to its board, management, and external consulting team to assess monetization options. The company has ruled out establishing a REIT as its analysis concluded there would be limited value created for shareholders and it would be a leveraging event.

However, Macy's believes there is potential for value creation from partnership or joint venture opportunities for its flagship properties (Herald Square, Union Square in San Francisco, State Street in Chicago and Downtown Minneapolis) where square footage could be partially repurposed, such as the partnership with Tishman Speyer on its downtown Brooklyn store to redevelop part of an existing New York-based store into office space. These transactions could be for individual properties or could extend to its mall-based stores and be significantly more broad-based than these four properties. The company has also been monetizing less productive stores in weak malls.

Fitch believes real estate monetization would be credit-neutral at best due to the potential addition of rent expense (if a location is sold into a joint venture) and the possibility that sale proceeds would be deployed to shareholder-friendly activities. However, Fitch's current ratings incorporate that Macy's does not take any action that yields leverage outside their stated target of 2.5x-2.8x (or 2.4x-2.7x using Fitch's 8x rent capitalization calculation).

The company continues to close underperforming stores with 41 stores that contributed approximately $375 million to sales (just under 1.5% of revenue) slated to close by spring 2016.

KEY ASSUMPTIONS

--Comp store decline of 1%-1.5% in 2016 and positive 1% thereafter. Top line growth expected to be down around 2% annually (besides 2017 which will benefit from a 53rd week).
--EBITDA declines approximately 5% to about $3.3 billion in 2016 and remains relatively flat thereafter. This assumes gross margin improves 40-50 bps in 2016 and remains relatively flat thereafter. SG&A dollars are expected to be flat annually.
--EBITDA margin declines modestly to 12.5% in 2016 and remains in the 12.3%-12.5% range thereafter versus 12.8% in 2015 and 14.2% in 2014.
--FCF improves to $900 million in 2016 from $415 million in 2015 due to modest use of working capital (versus over a $300 million drain in 2015) and capex reduction to $900 million from $1.1 billion. FCF is expected to be approximately $650 million in 2017.
--Adjusted debt/EBITDAR of 2.6x-2.7x.

RATING SENSITIVITIES

A negative rating action could result if negative same-store sales trends persist and/or the company changes its financial strategy (including deployment of proceeds from real estate partnerships or joint ventures towards shareholder friendly activities) that elevate leverage above 3x on a sustained basis.

A positive rating action could result if comps outperformance and share gains are sustained, while having and maintaining a public commitment to operate with an adjusted leverage in the low 2.0x range. This is not anticipated at this time given Fitch's expectation that Macy's will operate at the high end of its publicly stated target of maintaining leverage in the 2.5x to 2.8x range (using the company's calculation methodology which translates into 2.4x-2.7x on Fitch's calculation that capitalizes rent at 8x).

LIQUIDITY

Liquidity was supported by a cash balance of $1.1 billion as of Jan. 30, 2016. In addition, Macy's had full availability under its $1.5 billion credit facility due May 2018. Fitch expects Macy's to access the commercial paper market to fund seasonal working capital needs during the third quarter. For example, Macy's had $791 million in commercial paper outstanding at the end of 3Q15 to fund seasonal working capital.

FCF could improve to $900 million in 2016 from $415 million in 2015 due to modest use of working capital (versus over a $300 million drain in 2015) and capex reduction to $900 million from $1.1 billion. FCF is expected to be approximately $650 million in 2017 assuming capex is around $1 billion as the company invests in its store base and continues to fund growth-related initiatives. Macy's expects to pay down its $650 million debt maturities in 2016 as the company issued $500 million in debt in December 2015 to prefund these maturities. Going forward Fitch expects Macy's to use FCF towards share buybacks and to refinance debt maturities.

FULL LIST OF RATING ACTIONS

Fitch has taken the following rating actions:

Macy's, Inc. (Macy's)
--Long-term IDR downgraded to 'BBB' from 'BBB+';

Macy's Retail Holdings, Inc. (MRHI):

--Long-term IDR downgraded to 'BBB' from 'BBB+';
--$1.5 billion bank credit facility downgraded to 'BBB' from 'BBB+';
--Senior unsecured notes and debenture downgraded to 'BBB' from 'BBB+';
--Short term IDR affirmed at 'F2';
--Commercial paper affirmed at 'F2'.

The Rating Outlook is Stable.

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