After spending huge sums of money on share repurchases in recent years, Macy's (M -1.66%) has indicated that it will focus on reducing its debt in 2017.
This is a wise move. It will lower the company's annual interest payments, making Macy's a less risky investment. It will also position Macy's better to participate in future consolidation within the department-store sector.
Macy's should be able to pay down a lot of debt this year. Let's look at how it can carry out its debt-reduction plans.
Sizing up free cash flow
Free cash flow is the primary source of funds that Macy's could use to pay down debt. Despite having a disappointing year in 2016, Macy's generated strong free cash flow of about $900 million.
The company expects to produce a similar earnings performance in 2017. Furthermore, while Macy's plans to make roughly $177 million in cash payments this year related to its ongoing restructuring plan, it probably generated some extra cash this quarter as it cleared out the inventory from dozens of stores that recently closed or are about to.
As a result, Macy's could produce about $900 million of free cash flow again in 2017. It will spend approximately $460 million on dividend payments, based on its current dividend of $1.51 per share, but that should still leave $400 million to $500 million for debt reduction.
Real estate sales and cash on hand are also available
Macy's will also bring in some cash from real estate sales this year, albeit not as much as the $673 million it received last year.
The company has publicly announced that it sold its Minneapolis flagship store for $59 million. It also appears to have sold several other properties, generating tens of millions of dollars of proceeds. Based on this strong start, asset sales could bring in $150 million to $250 million of cash for Macy's this year.
A third potential source of funds is cash balances. Macy's ended fiscal 2016 with $1.3 billion of cash and cash equivalents on hand, up from $1.1 billion a year earlier. This higher level of cash on hand may simply reflect the fact that Macy's received a lot of cash from asset sales near the end of fiscal 2016.
Going forward, Macy's shouldn't need to keep as much cash around. The company has just $48 million of debt maturities in the 2018 and 2019 fiscal years combined. In addition, Macy's is shrinking because of its ongoing store closures, which should mean that it needs proportionally less cash. Lastly, the company has a $1.5 billion line of credit to meet any short-term liquidity issues.
A $1 billion year-end cash balance should be more than adequate for Macy's. That would free up an additional $300 million to repurchase debt.
More bang for the buck
Between its free cash flow, asset sales, and excess cash, Macy's should have at least $850 million -- and perhaps more than $1 billion -- available to pay down debt this year. $309 million will be needed for Macy's 2017 debt maturities. Macy's can use the rest to repurchase debt in the open market.
Right now, a lot of the company's bonds trade at a discount to "par" -- the principal that would be repaid at maturity. That means Macy's should be able to repurchase some of its long-term debt at a discount.
For example, its 2043 bonds recently traded at just $0.79 on the dollar. At that price, Macy's could repurchase the entire $250 million issuance for less than $200 million. Similarly, Macy's could buy back its $550 million of outstanding 2034 bonds for less than $475 million based on the recent quoted price of about $0.86 on the dollar. (The company's 2042 bonds trade at a similar level of $0.87 on the dollar.)
Since Macy's wants to reduce its gross debt as much as possible to meet its leverage target, repurchasing bonds that are trading below par seems like a no-brainer.
Based on the bonds' recent prices, Macy's could repurchase all $500 million of the 2042 and 2043 bonds for about $415 million. Assuming it had a total of $900 million available for debt reduction in 2017, Macy's would still have enough money left over (after paying off its 2017 debt maturities) to repurchase more than $200 million par value of its 2034 bonds.
In short, Macy's could potentially use $900 million this year to reduce its debt by a little more than $1 billion. Assuming that its earnings are flattish year over year, this would get the company back into its long-term leverage target range.
Good news for investors
Macy's entered 2016 with far too much debt on its books. However, it paid down about $750 million of debt last year, and it should be able to reduce its debt by another $1 billion or so in 2017.
Of course, this will lead to significant interest expense savings going forward. It also means that Macy's will be able to return to a more balanced deployment of its excess cash in 2018 and beyond. That means shareholders will be in position to reap the benefits of the company's strong cash flow and its real estate monetization efforts going forward.