1 I.

Executive Summary In 2010 and 2011, Macys has done an excellent job of generating top-line growth in a weak economy and has enhanced the efficiency of its operations by cutting SG&A expenses and closing underperforming stores and business lines. The companys continued ability to generate 5-6% revenue growth should continue as the economy picks up steam, disposable personal income begins to rise, consumers become more confident, and they spend more on discretionary items. I estimate a 12-month price target of $49.28. Macys stock currently trades at $39.98. Therefore, I rate this stock a BUY. II. Industry Analysis Department Store Retailing Growth Determinants Because most items sold in a traditional department store are discretionary items, department store retailers growth prospects are cyclical in nature and directly tied to the health of the domestic economy. As a result, the most important determinants of industry growth are the growth rate of disposable income, consumer confidence, the national unemployment rate, and population growth. Each of these is briefly discussed below: 1. Growth Rate of Disposable Income As stated, department store sales depend directly on the health of the domestic consumer sector. As the growth of disposable income declines or slows, consumers cut back on spending by delaying purchases or substituting for inferior goods. Generally, stronger economic activity is associated with more robust growth in disposable income. As you can see in the graph below (Figure 1), I expect continued modest growth in disposable income to near 5.5% by 2015 & remaining steady for at least the next 5 years. This modest growth is consistent with the continuation of the current L-shaped recovery of the US economy.

2 Figure 1 (above): Modest acceleration of growth in DPI to an average 5.5% is consistent with the current L-shaped trajectory of the US economys recovery 2. Consumer Confidence Consumer confidence levels determine the number and frequency of purchases. Low confidence causes consumers to delay purchases or buy less expensive substitutes. On the other hand, high consumer confidence makes people feel better about their economic future and more likely to make discretionary purchases. Because this economic data series is quite volatile, it is usually very difficult to forecast with any real precision. However, as the mild recovery continues, consumer sentiment has continued to trend up. I expect this trend to continue as the recovery continues on the same trajectory.

3. National Unemployment Rate The national unemployment rate is inversely related to the demand for discretionary goods, like are sold by department store retailers. When unemployment rises, consumers are likely to reduce their spending at department stores. When it falls, they are likely to increase their spending. The US unemployment rate has continued to gradually fall since the end of 2011 in line with the mild trajectory of the economys recovery. Below is a graph of recent historical and projected unemployment data (Figure 2).

Figure 2: Domestic unemployment should continue to gradually fall, boosting demand for department store discretionary goods 4. Population Growth Population growth is obviously an important contributor to growth because as population increases, so does the industrys customer base. Also, it is important for department store retailers to focus their efforts on areas experiencing the highest rates of population growth in order to maximize their potential customer base. As I will discuss in the following section, Macys has

3 done an excellent job at focusing its growth strategy around areas with the greatest population growth. Key Success Factors for Profitability The following are the most important factors affecting the profitability of players in the department store retailing industry: 1. Ability to Tightly Control Inventories Held Department store retailing is both cyclical and seasonal. It is essential that industry players implement tight inventory controls in order to ensure that popular items are available and to minimize working capital requirements and storage expenses. 2. Ability to Expand and Contract Operations with Changes in Demand As mentioned, the industry is both cyclical and seasonal. Players must be able to quickly and efficiently expand and contract operations to minimize working capital requirements and operating expenses 3. Desirable, Attractive, & Broad Product Selection Department stores require an effective layout and design of products that customers want to purchase. Additionally, customers want the ability to purchase all of the personal and household goods that they want in one place. Unless these conditions are met, the full potential of sales generated from a given level of inventories and operating expenses will not be realized 4. Ability to Effectively Price Products Since the most recent recession, consumers have segregated themselves into groups that prefer to shop prices over brands and those who prefer to shop brands and, generally, ignore prices. Companies who have found themselves stuck in the middle have hard a hard time appealing to either customer group and have suffered. III. Company Analysis Macys, Inc. Products & Markets As is evident in the table below, Macys gears most of its products toward women, but it offers products across the typical department store spectrum encompassing menswear, childrens apparel, and products for the home.

4 The assortment of merchandise offered at each store varies depending on the size of the store, the merchandising character, and customers shopping behavior in the local trade are Additionally, Macys is considered a mid-high end retailer, offering mainly higher end products at a premium price. As discussed before, it has become increasingly important for department store retailers to establish themselves as either discount sellers or high-end retailers. As a high-end retailer, Macys is able to pass the majority of any potential increases in its cost-of-goods sold off to its customers without much of an effect on revenues. Strategic Overview Since late 2007, Macys has pursued a broad strategy of localization, consolidation, and cost-cutting initiatives in order to increase margins and boost profitability. Its most important goals were implemented under the My Macys Localization Initiative, which had the following objectives: Accelerate growth in existing locations by making sure that merchandise assortment, size ranges, marketing programs, and shopping experiences are tailored to local needs Concentrate on more high-level management talent in local markets & the gathering of local intelligence for better decision-making Eliminate redundant division central offices & reducing other administrative expenses

Recent Strategic Results 1. Falling Selling, General, and Administrative Expenses Since beginning its strategy overhaul in early 2008, the companys efforts to cut administrative expenses by consolidating management and administrative offices have resulted in the company curbing and actually reversing its rise in SG&A expenses as a percent of revenue. This reversal is shown in Figure 3 below:

Figure 3 (Above): Management and Administrative office consolidation has reversed Macys upward trend of SG&A expenses as a % of Revenue 2. Falling PP&E as a Result of Store Closings Since 2007, Macys has divested itself of underperforming business lines like its Davids Bridal and Leonard Green brands and has shut down its biggest underperforming stores. As a result, Macys PP&E has decreased over 23% on a nominal basis and has decreased from 42% to 32% of revenues since 2007, without any impairment to top-line growth. 3. Superior Post-Recession Sales Growth While the rest of the department store retailing industry experienced significant declines in sales in 2010 & 2011, Macys enjoyed about 6% growth each year. Focusing the companys organic growth in areas of the country with the highest population growth primarily the Southern states and improving its in-store product selection with data collected in the My Macys Localization Initiative were key in generating this superior growth. Macys sales growth over industry average growth is plotted in Figure 4 below:

Figure 4: Macys sales growth has consistently outpaced the industry average SWOT Analysis Strengths o Managements ability to effectively implement companys strategy to increase operating efficiencies o Ability to pass COGS off to customers without suffering top-line losses

6 o Effective product localization strategies drive superior growth o Cost-effective SG&A expenses and deployment of invested capital Weaknesses o Declining portfolio of exclusive products and private labels o Very little global presence o Not meeting expectations for inventory controls Opportunities o Expand the companys online presence & develop a platform to integrate the customers in-store, online, and mobile shopping experiences o Potential acquisition targets in struggling retailers like Penneys, Kohls, etc. o Potential for growth & expansion into growing emerging markets Threats o American and/or European debt crises could stall the American economic recovery or trigger a second recession o Inability to compete on price with big-box retailers and online retailers. o Continued unemployment and low consumer confidence could squeeze discretionary spending o Continued weakness in the housing market could adversely affect the sale of home furnishing merchandise

IV. Projections & Valuation Projections & Assumptions A. Revenue Growth Historically and intuitively, department store retailers revenues are primarily driven by consumer confidence, the rate of unemployment, and the change in the level of personal disposable income. As stated before, all of these series are interrelated, and consumer confidence figures tend to be very volatile. Therefore, I find it most instructive to analyze the relationship between DPI growth, the unemployment rate, and Macys annual sales growth figures. This relationship is shown in the graph below (Figure 5).

7 Barring the outlier in 2006, it appears that Macys revenue growth is primarily driven by the current years growth in Disposable Personal Income, while the direction of the unemployment rate imparts a slight inversely-related drift factor. Therefore: When unemployment is on the rise, Macys revenue growth tends to accelerate at the same rate as DPI, but at a slightly lower level. When unemployment is flat, Macys revenue growth appears to match the growth in DPI with respect to both growth rate and acceleration rate When unemployment is falling, Macys revenue growth tends to outpace that of DPI, but with approximately the same acceleration I believe that the most likely scenario for the U.S. economy is that it will continue to slowly improve, consistent with the trajectory generated by an L-shaped recovery. This entails a gradual reduction in the unemployment rate toward a longterm average of around 4% by 2021 and stabilization of DPI growth in the range of 5.0-5.5%. The chart of expected revenue growth rates through 2020, which are consistent with the historical trends and projected trajectories discussed above are located in the table below (Table 1):

Table 1: Note that these growth rates are consistent with the graph of the relationships modeled in Figure 5 above. B. Cost of Goods Sold While Macys has very little control over its cost of goods sold, the company has historically been able to pass off nearly all of its cost increases off to its

8 customers. I expect the company to maintain this capability and project COGS as a percentage of revenue to remain constant. C. Property, Plant, and Equipment Macys has taken great care since 2007 to overhaul its operations, shutting down unprofitable stores and business lines to increase operating efficiency. They have had tremendous success with this strategy, as they have decreased PP&E by nearly 35% with sales growth of near 6% in 2010 and 2011. While efficiency will remain a priority, I believe that the company is reaching a point of decreasing marginal benefit in its pursuit of operating efficiency. Realistically, Macys can decrease PP&E as a percent of sales by another 3-4% to 29% of revenues within the next 5 years. Beyond that, I find further decreases to be unsustainable to maintain healthy growth. D. SG&A Expenses Toward the goal of increasing efficiency, Macys has also made reducing SG&A expenses a critical goal by consolidating regional back offices, cutting its sales force, and cutting redundant upper management. Similar to PP&E, I believe that Macys will find it difficult to cut SG&A much further before eroding its sales growth. I believe they can cut SG&A expenses by another 2-3% of sales over the next 5 years, and would do extremely well to maintain that level. E. Inventories On recent quarterly earnings calls, management has stressed their desire to get a tighter control on its in-store inventories, but has yet to have much lasting success. On the most recent call, management hinted that controls are likely around the next bend. I give them the benefit of the doubt, but I believe they can only have moderate success, as the companys inventory controls are already comparatively good by industry standards. I believe the company can reduce inventories by about 1% of annual sales over the next 5 years. F. Weighted-Average Cost of Capital I used the CAPM method to generate Macys cost of equity. I used an historic average of 10.6% for the market rate of return, the current yield on a 10-year Treasury with mean reversion toward an historic average of 3.65%, and Macys current beta of 1.36 with mean reversion toward the industry average 1.29. Additionally, I assumed that since Macys is a mature firm, they are currently operating at their target capital structure of 35.64% debt and 64.36% equity. The firms average after-tax cost of debt was estimated by Bloomberg to be 1.82%.

9 G. Terminal Growth Rate Terminal growth rates can be as high as, but no higher than the long-run average of the growth rate of the economy in which it operates. In general, terminal growth rates of relatively fast growth industries should be closer to the long-run average of GDP growth and slow growth industries should have lower terminal growth rates. Historically, the United States has experienced an average growth rate of GDP of 6.5%. I believe that this rate of growth will be difficult to maintain going forward because of the growing national debt issues. I estimate long-term growth in U.S. GDP to be 5% going forward. Because Macys is in a slower-growth industry, I believe that 3% is an appropriate growth rate in the estimation of terminal value. Valuation Discounted Cash Flow Model This valuation model employs scenario analysis to capture the effects of deviations from assumptions made about the economy, business environment, and Macys strategic success going forward. Scenario 2 is the base-case scenario, and all of the assumptions and justifications explained above apply directly to this case. I believe that this is the most likely case and give it 60% of the weight for the final valuation. Scenario 2 resulted in an estimated equity value per share of $46.46. Scenario 1 is the best-case scenario. While sales growth estimates are the same as in the base case, assumptions about diminishing marginal effectiveness of strategic goals is relaxed a bit. SG&A expenses as a percentage of revenue and PP&E as a percentage of revenue are allowed to decrease for twice as long as in the base case. Scenario 1 was given 20% of the weight for the final valuation and resulted in an estimated equity value per share of $76.69. Scenario 3 is the worst-case scenario, and it models for poor economic growth and poor firm strategic success. Sales grow at less than half that of the first and second scenarios for the first 5 years of the forecast period, and it is assumed that the company is unable to reduce SG&A expenses and PP&E as a percentage of revenue any further. Scenario 3 was given 20% of the weight for the final valuation and resulted in an estimated equity value per share of $30.32.

I estimate Macys final weighted-average equity value per share within the next 12 months to be $49.28. The final closing price as of April 13, 2012 was $39.98. Therefore, I rate Macys a BUY. Macys historical integrated financial statements, projected statements, and the valuation model used are in the appendix below.

10 Comparable Ratios Comparable ratios can be a useful tool toward putting valuation estimates into some market-driven perspective. In Macys case, comparable ratios appear to confirm my conclusion that Macys is undervalued. Macys P/E, PEG, Price/Book, and Price/Sales ratios along with industry averages are below:

Note that each of these ratios indicates that Macys may be fairly undervalued.

11 Appendix I: Historical Integrated Financial Statement

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Appendix II: Forecast Ratios Scenario 1

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Appendix III: Forecast Ratios Scenario 2

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Appendix IV: Forecast Ratios Scenario 3

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Appendix V: Forecasted Integrated Statement Scenario 1

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Appendix VI: Forecasted Integrated Statement Scenario 2

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Appendix VII: Forecasted Integrated Statement Scenario 3

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Appendix VIII: Valuation

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