Betting on restructuring is a dangerous game
Businesses stop creating value at a certain point in their lifecycle. Rather, they start to destroy it.
Once a business has declined substantially, its returns on investment drop below cost of capital. It loses its competitive advantage and its market share dips lower than it has in years.
At this point, growing the business’s assets may just be futile. It will just create more financial harm for the company.
New investments with barely any return potential will lead to less cash on hand to pay for other obligations. These companies are gasping for air in the market and may benefit from divesting their worst assets to stay alive.
But companies can get out of this disastrous place. This is their opportunity to restructure.
By adjusting their operating model or strategy, companies can improve their prospects.
Last time, we discussed how Macy’s had been declining recently. Let’s take a look at Macy’s again today to analyze its future restructuring opportunity after that experience.
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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.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research