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Executive Summary: (Macy’s Inc.)

Investment Recommendation: Overvalued, Sell (Nov. 1, 2007)

M- NYSE(11/1/07): $31.54 Altman Z-Score 52 Week Range: $27.18 - $46.70 2002 2003 2004 2005 2006Revenue: $26.88 billion 2.65 3.14 3.18 2.8 2.21Market Capitalization: $13.51 billion Shares Outstanding: $433 million Valuation Estimates 3 month avg. daily trading volume 6,089,440 Actual Price (11/1/07): $31.54 Percent Institutional Ownership: 92.4% Book Value per Share: $21.80 Financial Based Valuations ROE: 8.16% Trailing P/E: $23.01 ROA: 4.54% Forward P/E: $60.69 P.E.G.: $74.82 P/B: $75.96 Cost of Capital Est. R2 Beta Ke P/EBITDA: $61.12 Estimated: P/FCF: N/A 3 month 0.088 1.26 14.72% EV/EBITDA: $2.46 1 year 0.087 1.25 14.64% 2 years 0.086 1.25 14.64% 5 years 0.085 1.24 14.55% Intrinsic Valuations 7 years 0.084 1.24 14.55% Discount Dividend: $4.99 10 years 0.084 1.23 14.47% Free Cash Flow: $67.86 Residual Income: $17.65 Published Beta: 1.03 LR ROE: $15.07 Kd(AT): 6.22% AEG: $15.01 WACC(BT): 10.26% WACC(AT): 9.11%

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Industry Analysis

In 1858, Mr. Rowland Hussey Macy established the first Macy's

department store in New York City under the name R. H. Macy & Company.

Today, Macy's is a chain of mid-range American department stores with its

flagship store in Herald Square, New York City. This store’s one million square

feet of selling space has been dubbed as the "world's largest store,"

(Wikipedia.com). As of July 2007, Macy's operates 876 stores in 45 states, Puerto

Rico, and Guam. In addition to the physical locations, customers can now shop

Macy's via Internet or through one their mail order catalogs.

Direct competitors for Macy's are Nordstrom, Saks 5th Avenue, and

Dillard's. Ultimately, competition among existing firms is based upon price and

customer loyalty. Therefore, economies of scale and tight cost controls are the

frontline in the battle for market share. This practice makes it extremely difficult

for new firms to enter into the market, nearly alleviating the threat of new

entrants. Furthermore, since competing firms sell much of the same

merchandise, switching costs for the consumer are low and the threat of

substitute products is high. This forces firms to compete on customer service in a

big way.

Marketing strategies that attempt to differentiate are also crucial in the

competition for market share. Existing companies try to differentiate themselves

through exclusive contracts with big name brands to lure in customers. However,

the bigger the name, the more bargaining power the supplier has over the firm.

For the most part though, bargaining power of the suppliers remains relatively

low in this industry.

In the high-end retail industry, there are a handful of competitive factors

that are key tools in gaining market share and a competitive advantage. These

key factors are economies of scale, low input costs, and investment in brand

image. Excellence in these key factors will provide a dominating edge against the

competition in the fight for market share.

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Accounting Analysis

The ability to match key accounting policies with key success factors is

what determines profitability. Under the flexibility allowed by GAAP and

aggressive accounting styles, window-dressing is an ever-growing concern for

investors. Therefore, accounting analysis is a key tool in finding any irregularities

in a firm's financial statements and determining the transparency of the

information presented.

One of Macy's key accounting principles is the way it presents its liabilities

for operating and capital leases. Like most of its competitors, Macy's uses a

majority of operating leases. However, using an operating lease poses a problem

because it grants the firm some flexibility in reporting expenses. To head this

problem, Macy's discloses the future operating and capital lease obligations for

the next five years, with the remaining obligation after five years appearing in

the footnotes of the financial statements. Pension funds are another area of

flexibility. Depending on the chosen discount rate, a firm may be able to reduce

the present value if its pension liabilities. However, Macy's maintains its

transparency by listing all discount rates, changes in discount rates, and any

additional changes. For example, in 2006 Macy's raised its pension discount rate

by .15%, lowering the line item pension expense. But, it also made "voluntary"

contributions to the pension plans in 2005 and 2006 of $136 and $100 million,

respectively.

Upon our conclusion of the accounting analysis, we found that any "red

flags" we had discovered were easily explained and in fact, normal. This further

demonstrates that Macy's does well in disclosing plenty of transparent

information in its 10-K.

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Financial Analysis, Forecast Financial, and Cost of Capital Estimation

In order to better forecast a firm’s financials, analysts use a series of

financial ratios that evaluate a firm’s liquidity, profitability, and capital structure.

When computed correctly, these ratios provide analysts with data that is used to

compare a firm to its competitors and forecast the firm’s financial statements.

After this is done, a regression table is made to estimate a Beta for the firm.

Also, the cost of debt, cost of equity, and weighted average cost of capital are

computed.

We found that Macy’s liquidity, when compared to their competitors, is

disappointing. Macy’s liquidity ratios such as: current ratio, quick asset ratio, and

working capital turnover were either below the industrial average or in decline.

However, after computing Macy’s profitability ratios, we discovered that they are

extremely productive. When compared to their competitors, Macy’s gross profit

margin, operating profit margin, net profit margin, return on assets, and return

on equity dominate the industry. The only exception is their asset turnover,

which is dismal compared to their competitors. This could be explained by their

high profit margins, but is still a concerning matter for top management. Finally,

Macy’s capital structure ratios were promising. When compared to the industry,

they’re times interest earned ratio was at the top. Also, their debt to equity ratio

is right in line with the industry average. However, Macy’s does have a poor debt

service margin, indicating they may be having some trouble covering their long-

term debt. From this, we can conclude that Macy’s strength lies in keeping its

interest expenses low, while increasing its cash flows.

Using growth rates and the ratios previously discussed, we

forecasted Macy’s financial statements for the next ten years. The processes that

we took to forecast the financial statements varied for each statement. To

forecast the income statement, we first computed the common sized income

statement, which stated each item as a percentage of net sales. Then, we

calculated a personalized growth rate for each account. We used these growth

rates to forecast the income statement items for the upcoming years. Next, we

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used the liquidity, profitability, and capital structure ratios that we computed to

forecast the balance sheet. The statement of cash flows was the most difficult to

forecast because there were inconsistencies which caused us to make a few

assumptions during this process. Due to the uncertainty, we find the cash flows

forecast to be the least reliable of our forecasts.

Valuations

We use valuations to estimate Macy’s share price. Then, we compare our

estimations to the observed share price as of November 1, 2007, to illustrate

whether Macy’s is over or undervalued. We started our valuations with the

methods of comparables, which include: P/B, P/E (trailing and forward), PEG

ratio, P/EBITDA, and EV/EBITDA. When we calculated Macy’s share price based

on these methods, we found that Macy’s observed share price is undervalued.

On the other hand, when we used the intrinsic valuations, we discovered Macy’s

is in fact overvalued.

The intrinsic valuation methods that we used to further explore Macy’s

share price were Discounted Dividend, Free Cash Flow, Residual Income,

Residual Income Perpetuity, and the Abnormal Earnings Growth rate models. To

use these models, we used our forecasted financial statements, Ke, WACC

(before tax), and growth rate.

Under the discount dividend model, we found that Macy’s is overvalued.

In addition, the residual income, residual income perpetuity, and AEG models all

concluded that Macy’s is overvalued. However, the free cash flow model

demonstrated that Macy’s is undervalued. After all of our research and

evaluations, we feel the calculations that produced overvalued results for Macy’s

are the most accurate. Therefore, we believe that Macy’s is overvalued and our

stock advice is to sell.

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Business & Industry Analysis

Company Overview

The first Macy’s (M) was created by Rowland Hussey Macy in 1858. They

are now based in Cincinnati, Ohio. Over the last 150 years, Macy’s Inc. (formerly

known as Federated Department Stores, Inc.) has built itself into a giant in the

“high-end” retail industry. “As of February 3, 2007, the company operated more

than 850 retail stores in 45 states, the District of Columbia, Guam and Puerto

Rico under the names Macy’s and Bloomingdale’s” (Macy’s 2007 10-k). These

stores sell a variety of merchandise to their consumers. Some of these items

include clothing for all ages and genders, cosmetics, home furnishings, and other

accessories.

Macy’s Five-Year History

2006 2005 2004 2003 2002

Total Assets* 29,550,000 33,168,000 14,885,000 14,550,000 14,441,000

Net Sales* 26,390,000 22,390,000 15,630,000 15,264,000 15,435,000

Comparable

Sales Growth 30.35% 36.65% (2.32%) (2.9%) 1.76%

*in thousands

Macy’s main competitors in the “high-end” retail industry include Dillard’s,

Saks, and Nordstrom. Though Nordstrom’s Market Cap is comparable to Macy’s,

Macy’s has supremacy over the entire industry. Macy’s revenues more than triple

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its nearest competitors last year. The acquisition of a group of stores explains

the leap in comparable assets for Macy’s in 2005. This merger made Macy’s an

even more dominant force in the high-end retail industry. Macy’s stock reached a

five year peak of 45.05 in March of 2007. However, the price history for this

market shows a slightly different story from the 2007 10-Ks. Nordstrom’s has

clearly been the “hot” stock in this industry for the past few years. Macy’s is still

far too large to be worried by Nordstrom’s recent market boom, but it is

definitely something to be monitored in the near future.

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Industry Overview

The high-end department store retail industry is an intensely

competitive market. Most of the products sold in this industry are the same from

store to store. This puts a lot of pressure on each company to create a loyal

following, since it is easy for unsatisfied customers to go to other stores.

Consumers in this industry are looking for the highest quality, name-brand

merchandise. Price of the products is a secondary priority to these buyers. It is

difficult for new entrants to take away business in this industry because all of

these firms are well-set in the market. For instance, Nordstrom was founded in

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1901; Saks was founded in 1919, and Dillard’s in 1938. Smaller, ‘flavor-of-the-

week’ companies may have come and gone in that time period, but these big

three have been competing with Macy’s for over 70 years. Nordstrom “derives its

revenues from sales of high-quality apparel, shoes, cosmetics and accessories”

(Nordstrom 10-K). They have 155 stores throughout the United States and also

have businesses in 45 other countries. Saks Inc. consists of Saks 5th Avenue, Off

Fifth, and Club Libby Lu. Of these stores, Saks 5th Avenue is the only one

competing in Macy’s industry offering a “wide assortment of distinctive luxury

fashion apparel, shoes, accessories, jewelry, cosmetics, and gifts” (Saks 10-K).

Saks Inc. owns 190 stores, 54 of which are Saks 5th Avenues. These 54 stores

are a very small portion of market share in comparison to Macy’s 850,

Nordstrom’s 155, and Dillard’s 328. Dillard’s Inc. is based out of Little Rock,

Arkansas. They “rank among the nation’s largest apparel and home furnishing

retailers. Dillard’s stores offer a wide selection of merchandise including fashion

apparel for women, men and children, accessories, cosmetics, home furnishings

and other consumer goods” (Dillard’s 10-K). As stated above, these 10-K reports

show that creating a loyal customer base is crucial for success in this industry.

With all of these firms selling the exact same types of merchandise,

differentiation is extremely important in this market.

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Five Forces Model

The five force model is a useful tool used to help analyze the industry in

which firms compete. This model helps to give the general feel of the industry

and give a better understanding of how a firm can be profitable. It is, however,

just a single tool in a large systematic analysis of an industry. Also, the five force

model includes five major topics: rivalry among existing firms, threat of new

entrants, threat of substitute products, bargaining power of buyers and

bargaining power of suppliers. These major topics are then broken down into

smaller subtopics and generally discussed to help us see exactly what a firm

needs to do, in order to be successful in the industry.

After going through the five force model, a value chain analysis will then

be formulated. This will explain how Macy’s has not only been able to stay alive,

but continue to be a successful powerhouse in the high-end retail department

industry.

HIGH – END RETAIL INDUSTRY

Rivalry among existing firms VERY HIGH

Threat of new entrants LOW

Threat of substitute products HIGH

Bargaining power of buyers HIGH

Bargaining power of suppliers LOW

Rivalry among Existing Firms

The high-end retail industry is a highly saturated industry thus very

competitive, and this leads to firms being forced to fight for market share.

Ultimately competition is based on price and customer loyalty. Even though the

high-end retail industry is characterized by high prices, firms need to be careful.

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Setting prices too high may scare new customers back to the open arms of its

competitors and possibly chase away loyal customers. Firms in this industry are

forced to fight for market share by striving to differentiate their products or offer

incentives that appeal to customers. Late store hours for convenient shopping

and better customer service with excellent exchange and return polices are a few

existing examples in this industry.

Industry Growth

Growth in the high-end retail industry is very slow. This discourages new

entrants and forces firms in this industry to be innovative in order to grow. As

shown in the diagram above growth is very slow, if at all. Nordstrom however,

has been growing steadily over the last five years, and Macy’s sales were low

until 2005 when their sales shot up. Therefore, just because the industry in

general shows slow growth a firm can be innovative and still show growth. Most

firms grow by acquiring new stores or diversifying into other areas or businesses.

Some firms in this industry spend lots of money in advertising to attract new

-0.600 -0.500 -0.400 -0.300 -0.200 -0.100 0.000 0.100 0.200 0.300 0.400 0.500

2002 2003 2004 2005 2006 2007

Percentage Growth of Sales

Macy's Dillard's Saks Nordstrom

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customers. Other firms offer high limit store credit cards which lure people to

shop even when they do not have the money to do so. And the store is able to

make money on interest on the credit cards, thus increasing revenue.

Concentration

An industry with a lot of players or firms is considered to have high

concentration and this creates a lot of price wars. The high-end retail industry

falls in this category and thus they are forced to either acquire aggressive

merchandising or reduce prices to attract and keep the customers they have.

Industry Market Share

2002 2003 2004 2005 2006

Macy's 49.04% 48.32% 47.48% 55.36% 58.49%

Dillard's 24.90% 23.81% 22.73% 18.67% 16.56%

Saks 7.34% 7.66% 8.33% 6.87% 6.38%

Nordstrom 18.72% 20.22% 21.46% 19.10% 18.57%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

2002 2003 2004 2005 2006

Market Share

Macy'sDillard'sSaksNordstrom

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Market share is a percentage of industry sales. The above bar graph

shows how market share is distributed among the main firms in this industry. As

the graph shows, relative market share throughout the industry has remained

fairly constant. Macy’s has dominated the market for the last five years thus

creating high concentration in the industry. This leads to price wars, but in the

high-end retail industry, quality plays a big role because customers want high

quality and are willing to pay a higher price for it.

Differentiation & Switching Costs

The ability of a firm to differentiate its products from the other

competitors reduces competition in the industry. However, it is hard to

differentiate products in the high-end retail industry largely because many firms

in the industry share some of the same suppliers. This causes the same brand

name items to be sold in all the stores. Therefore, most firms strive to focus on

quality of customer service and sell name brand designer label items to justify

their high prices. Excellent customer service and long store hours influence

customers’ decisions to shop at a particular store. Switching costs in this industry

are low because it would be very expensive to liquidate the current inventory in

a particular store and start something else; meaning most firms are in it for the

long run.

Economies of Scale

In the high-end sector of the retail industry, firm size plays a key role in

success and the level of competition. Larger firms enjoy economies of scale,

giving them purchasing power with their suppliers and the ability to reduce

operating costs by spreading fixed costs over a larger base. The unique

relationship firms share with their suppliers allows them to make long term

contracts to buy in bulk. This process locks in large discounts for the firm that

can be passed on to the consumer and therefore attracting more customers.

Purchasing power also shields firms from the threat of new entrants seeking

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mutual suppliers. The table below shows that Macy’s dominates a large portion

of the market in the high-end sector of the retail industry.

Industry Sales

2002 2003 2004 2005 2006

Macy's 15,571,000 15,412,000 15,776,000 22,390,000 26,970,000

Dillard's 7,906,646 7,594,460 7,552,060 7,551,697 7,636,056

Saks 2,331,659 2,441,989 2,766,977 2,778,333 2,940,003

Nordstrom 5,944,656 6,448,678 7,131,388 7,722,860 8,560,698

Total Industry 31,753,961 31,897,127 33,226,425 40,442,890 46,106,757

*in thousands

Fixed Costs to Variable Costs

A firm’s ratio of fixed costs to variable costs is also a key determinant

when measuring its level of competition. In the high-end retail industry, it is not

uncommon for firms to have a low ratio of fixed costs to variable costs. This

means that for every dollar of variable costs the firm expends, they only spend a

fraction of a dollar in fixed costs. This gives the firm leverage to liquidate

inventory that’s not selling and shift their focus to new products. However, a

high ratio of fixed costs to variable costs indicates that the firm has a great

amount invested in its particular industry and is restricted in its actions.

Fixed Costs to Variable Costs Ratio

2002 2003 2004 2005 2006

Macy’s .6788 .6892 .6785 .6473 .9076

Nordstrom’s .4676 .4436 .4092 .3905 .3629

Saks .5674 .5731 .5530 .5123 .3583

Dillard’s .6274 .6415 .6184 .6339 .6300

*Ratios derived from the financial statements of Macy’s Inc., Nordstrom’s Inc., Saks Inc., &

Dillard’s Inc.

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Excess Capacity

Excess capacity occurs when a firm’s supply exceeds demand. In the retail

industry, this tends to happen towards the end of peak seasons. When it

happens, retailers discount their merchandise to make way for the next season’s

inventory. If the firm enjoys economies of scale, it is able to compete at a higher

level during excess capacity due to its purchasing power and cost control.

Same Store Operations

2002 2003 2004 2005 2006

Macy’s (14.9%) (1.3%) (1.1%) 2.4% 43.3%

Nordstrom’s 1.9% 6.1% 8.6% 9.9% 8.3%

Saks (7.8%) (2.6%) 2.4% 6.3% (7.5%)

Dillard’s (4.8%) (2.9%) (3.9%) 0.0% 0.0%

* Percentages derived from the financial statements Macy’s Inc., Nordstrom’s Inc., Saks Inc., &

Dillard’s Inc.

Same store operations are a way for firms to measure the productivity of

all their different stores. The table above shows the same store operations for

this industry. It is helpful to see the efficiency for all of the stores of each

company. These numbers allow each firm to evaluate how sales are compared

from store to store. For example, Macy’s stores down in Texas will most likely

have different sales than the stores in New York. The northern stores will find

higher sales volumes for the cold weather clothing, while the southern stores will

favor warmer attire. Therefore, it would be beneficial for the southern stores to

remove their cold weather inventory and ship them north, where their stock will

be more useful. The same concept applies for the northern stores sending their

warm weather inventories down south, thus, making all stores more efficient.

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Exit Barriers

Exit barriers are any obstacles that prevent a firm from leaving its

industry. Firms in the high-end retail industry have invested a lot of capital and

have a large amount off fixed assets that are not easily converted into liquid

cash, should they decide to leave the industry. If a company decided to leave the

market, it would be forced to liquidate large amounts of inventory.

Conclusion

In the high-end retail industry competition is intense. This is due to high

market concentration and an inability to differentiate products. Therefore, firms

seek economies of scale so they can maintain price control. Factors such as slow

growth, low switching costs, and few exit barriers also play key roles in the

highly competitive nature of this industry.

Threat of New Entrants

The threat of new entrants isn’t going to be very common because of the

magnitude of the operation. On average, a single Macy’s store is approximately

200,000 square feet. It would be very difficult for a new business to jump into

the industry and instantly become competitive. The stores are extremely large

and require a great deal of capital to begin operating. The small “mom and pop”

outfits throughout the country steal tiny portions of the market from Macy’s.

Large department stores will usually always have a cost advantage over smaller

stores due to the bulk of the purchases. This combination makes it hard for large

entrants to join the industry and small entrants are rarely effective in the overall

market share.

Learning Curve

A learning curve is low because the large department stores are already

established and the only threat of new entrants is rival companies merging and

acquiring stores of their competitors. Brand identities do exist to some degree.

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Though the DS only carry merchandise from other manufactures, I have to look

at brand identity as loyalty. Macy’s, Saks, Foley’s, etc., all carry just about the

same items, brand identity can be associated with customer service which then

really leads into differentiation, another subject all together.

Economies of Scale

Economies of scale plays a part in the large DS because they can

purchase more products from individual manufactures that, over a period of

time, drives the price down and the profits up. The threat of a brand new

company setting up and taking business away from the existing DS is highly

unlikely.

Distribution Access

The access to distribution channels is extremely easy for the large DS

because they have been doing business with one another for many years. This

has created a loyalty between the existing firms and suppliers that makes it very

difficult for a new DS chain to come and succeed. Suppliers would not want to

take a risk on a new company when they already have a strong relationship with

an older, reliable firm.

Conclusion

The difficult boundaries for any company thinking about joining the high-

end retail industry make in nearly impossible to join and compete. The large

companies that currently exist already have relationships with suppliers and are

able to get large quantities of merchandise for low prices. These relationships

make it nearly impossible for a new company to enter the industry and compete

on price. Smaller, new companies will have to find creative ways to differentiate

themselves from the existing competition in this industry.

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Threat of Substitute Products

In the high-end DS industry, the threat of substitutes will always be

present. This plays a big role because all department stores carry the same kind

of merchandise in each department. Therefore, the cost to the customer to

switch from one store to another is relatively low. Companies must compete on

other factors such as customer service and quality of goods sold.

Relative Price & Performance

Value has always been associated with price. Since you most likely will be

able to find similar items in different stores, Macy’s must justify its price with

superior service and quality. The price must always reflect the amount of value

perceived for that product and what you might get based on the price you pay.

Customers will find somewhere else to spend their money if they do not receive

exceptional service at a “high-end” store.

Buyers’ Willingness to Switch

The threat of substitutes will be just about the biggest factor in the retail

clothing industry. Companies must rely on differentiating themselves through the

service they offer their customers or by the particular brands they carry. A

customer is very likely to switch stores if they do not receive the satisfaction they

deserve or if they find similar products at other stores at a very competitive

price. Retailers must always take into consideration the extremely low cost for

consumers to switch stores. A strong customer base is what drives this industry.

Knowing this, retailers are required to cater to every need that their customers

desire.

Conclusion

Substitutes are the biggest threat in this industry, and because customers

can move so easily from one store to another, the companies focus on other

aspects they deliver in addition to their products to validate premium prices. That

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is why it is so important for a company to offer easy help, quick check-outs,

clean stores, friendly employees, and other “extras” to create a loyal customer

base as well as entice new customers to come to the store.

Bargaining Power of Customers

The bargaining power of customers plays a crucial role in the way a high-

end retail company forms its business model. A retail department store will

develop a pricing strategy, marketing strategy, and customer service department

based on the role that consumers have in their industry. The higher the

bargaining power a customer has over a firm, the bigger role pricing will play in

that firm’s business strategy.

Price Sensitivity

The high-end retail industry is a very price sensitive market. The

switching cost of customers in the high-end retail department stores is relatively

low. Switching costs are the costs that consumers will incur to change products

or suppliers in the marketplace. Most of the department stores generally carry

the same items and brands. For the most part, they are also located in the same

areas, such as malls or strip centers. This allows the customers to easily switch

between retailers based on price or other factors that they feel are important at

little to no extra costs to them. Clients have no obligation to shop at one specific

department store, so it is very easy for them to buy their products else ware.

The majority of products sold in retail department stores are relatively the

same from one store to the next. This makes it difficult for department stores to

differentiate themselves with their products. However, some retail stores can

separate from others by offering products that are higher quality or specialty

items. Companies like Macy’s, Dillard’s, and Nordstrom differentiate themselves

from large category killers like Wal-Mart by offering higher-end products that

they charge a premium for. Unfortunately, they still struggle to differentiate

themselves from each other, which force them to attract customers in other

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ways. Ultimately, this will come down to quality of customer service. If all of the

higher-end retail department stores are offering similar products, the consumer

will search for the retailer who offers the best shopping experience to add value

to their dollar. This is how these stores justify the higher prices that they charge.

High-End Retail Industry

34.00%

34.50%

35.00%

35.50%

36.00%

36.50%

37.00%

37.50%

38.00%

38.50%

2002 2003 2004 2005 2006

Gross Profit Margin

As shown in the graph, companies in the high-end retail industry have

begun steadily increasing their gross profit margin by increasing sales and

decreasing the cost of goods sold. Buying in bulk from their suppliers makes this

possible for these firms to accomplish. The more they buy at once, the lower the

cost. Then they continue to sell these large stocks of products, thus, increasing

sales.

Relative Bargaining Power

The high-end retail department store business is a very competitive

industry, and is driven solely by its customer base. The number of buyers in this

market is extremely large because of the vast number of products being offered.

However, the purchase volume per customer is relatively small, so the cost of

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losing one customer is not that significant on a monetary level. This limits

bargaining power of customers to a small extent, but not enough to outweigh

the low switching cost of the customers and the lack of differentiation in the

industry. Therefore, the buyers (or customers) in the high-end retail industry

have a high level of bargaining power.

Conclusion

The bargaining power of buyers will play such a major role in the way a

high-end retail company forms its business model. Firms competing in this

industry must accurately assess the price sensitivity and relative bargaining

power of its customers. The low switching costs for customers and minimal

differentiation between competing firms creates high price sensitivity and a high

bargaining power of buyers in this industry.

Bargaining Power of Suppliers

In the departmental retail industry, suppliers have minimal bargaining

power. This is mainly due to the fact that department stores use a wide variety

of suppliers. This allows retail companies to be more selective and provides them

with a greater amount of control involving the prices of products.

Price Sensitivity

In a particular industry where suppliers have a great amount of bargaining

power, prices will usually increase for both the firms and potential customers.

However, this is not the case for most retail department stores. If a supplier of

one of these stores does not agree to a specific condition regarding the time of

delivery or price, they can easily be removed as a supplier of the company.

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Relative Bargaining Power

In addition, suppliers of major retail department stores are aware that

there are a limited number of these stores that will sell their product to many

people at a profitable price. Therefore, this reduces the bargaining power of

suppliers. However, many suppliers of these high-end retail department stores

offer many respectable name brand products that are in high demand by both

the company and customers. In some cases where the particular brand is highly

valued, these suppliers may have slightly more bargaining power than other

suppliers.

The relationship between the firm and suppliers is important to the

success of both companies. Having a strong relationship helps to increase

efficiency and reduce the prices of products. However, it is important that a firm

does not depend on one particular supplier. In 2006, Macy’s did not order more

than 5% of it inventory from one supplier. Having this diversity among suppliers

allows the company to have more bargaining power.

Conclusion

The bargaining power of suppliers plays an important role in any retail

industry. The lower the bargaining power of the suppliers, the more beneficial it

is for the company purchasing the products for resale. In addition, many firms in

the departmental retail industry provide similar products. Therefore, the

switching costs are relatively low. As one can see, the bargaining power of

suppliers in this particular industry is low due to the wide selection of suppliers

offering similar products.

22

Value Chain Analysis

“The profitability of a firm is influenced not only by its industry structure

but also by the strategic choices it makes in positioning itself in the industry,”

(Palepu and Healy). The value chain analysis tells us exactly what the firm is

doing in order to stay ahead of the competition.

The value chain analysis will show what strategies the firm in the high-end

retail industry is taking in order to be efficient in producing and distributing its

products. We will then use the strategies from the value chain analysis to see

how Macy’s stacks up to the competition.

Economies of Scale & Scope

Economies of scale and scope play a major role in the high-end retail

industry because most firms in this industry are large in size. Size is important

because it enables companies to cut costs through quantity discounts. It would

therefore be advantageous for a company to sell the same merchandise in all

locations, in order to take advantage of the quantity discounts. Most of the

companies in the high-end retail industry are taking advantage of this by using

the internet to make products available to any customer, from any location in the

world. Economies of scope, on the other hand, “refer to the reduction of per unit

costs through the production of a wider variety of goods and services,” (Street

authority). This is usually achieved by producing small batches of many items.

Instead of just having one line of products, firms achieve economies of scale by

providing a variety of products and increase sales. The fact that existing firms

already have relationships with their suppliers discourages new entrants to the

industry. It would be hard for a new comer in the industry to achieve the same

success.

23

Low Input Costs

Low input costs are a plus in the high-end retail industry, because it

means producing and distributing at lower costs. It gives a firm the ability to

reduce prices and stay ahead of the competition. This is not always easy to

achieve in the high-end retail industry since they strive to produce high quality

goods. Lowering production costs usually means substituting high quality

materials with low quality materials, which would destroy quality. Firms in this

industry are sometimes forced to have markdowns to avoid having excess

inventory, which leads to reduction of profits. To avoid this, companies in the

high-end retail industry must keep up with new trends in order to avoid having

excess inventory. Also, maintaining supplier relationships ensures quantity

discounts, which is important to make up for lost sales.

Tight Cost Control

The high-end retail industry is an intensely competitive industry, thus

companies must strive to be innovative and ahead of the competition.

Companies not only compete on price, but also on quality of products. Therefore,

having a low cost strategy must be accompanied with a tight cost control system

in place. Tight cost control can be achieved by having distribution centers. Also,

centralizing organizational tasks can result in efficient control of inventory to

avoid having excess inventory. Having a good relationship with a supplier is

essential because it enables the firms to have a constant stream of inventory, in

a timely fashion, at a controlled or even reduced price.

Low Cost of Distribution

Distribution plays a big part in the high-end retail department. Most firms

in this industry store their merchandise in warehouses before distributing them

to other store. Also some firms in this industry own their own trucks and this

greatly reduces costs in that they can control how and when their merchandise is

to be picked up for delivery.

24

Superior Product Quality/ Variety/ Customer Service

Firms in the high-end retail industry strive to provide high quality

products. Firms in this industry know that their competitors offer most, if not all,

of the same products. It is important for a firm to differentiate themselves from

the competition. Excellent customer service and good shopping atmosphere are

two key ways used in this industry to create customer loyalty. Customer service

is hard to measure because it means something different to every person. One

customer may find the quality of service to be fantastic, while another customer

receives the same service and is disgusted with it. For this reason, it is important

for stores to have customer feedback. This way, if customers are not getting the

service that they feel they deserve, the stores can adjust to the customers’

needs. Also, offering a large variety of products provides the customers different

options to choose from. For example, offering different designers such as

Giorgio Armani, Tommy Hilfiger, and Ralph Lauren allows consumers the

opportunity to choose the designer that best fits their preferences.

Investment in Brand Image

Firms in high-end retail rely on brand image, because some of the

customers only buy certain brands of makeup, shoes, and handbags. Firms that

offer the most varieties create a following of loyal customers. A firm must

therefore strive to have good relations with certain brand retailers and ask to sell

there products exclusively in their stores. This not only attracts customers who

admire that label but ensures that you maintain them as long as you continue to

sell that particular label.

Conclusion

The high-end retail industry is very competitive and firms must therefore

strive to be profitable and separate themselves from the rest. Price is always

going to be a major factor in this industry, therefore, firms must strive to control

25

their costs so as not to be over priced and chase away their customers. By

lowering input and distribution costs, a firm is able to use those resources to

invest on their product and maintain a high standard.

The high-end retail industry puts a large emphasis on product quality. A

firm must adopt certain practices, like investing in product quality and variety, to

ensure a continual high quality product. Customer service is also very important

because providing a good shopping environment for customers is just as

important as providing a good product. The upscale, warm, and friendly

environment provided in this industry helps customers feel like the premium

prices they spend their money on are justified.

Firm Competitive Advantage Analysis

Competitive advantage is very important. It helps us see how well Macy’s

is utilizing cost leadership and differentiation tactics to stay on top of the

competition, which will lead to maximizing its profits. In order for Macy’s to be

operate efficiently they need to be able to lower input and distribution costs in

order to be a price leader. They also need to focus on superior product

quality/variety and customer service in order to retain the customer they already

have and ultimately attract new customer.

Economies of Scale & Scope

Macy’s is enjoying economies of scale based on its big size. They have

858 retail stores, allowing them to serve an extremely large market. This large

scale allows them to buy in bulk and take advantage of quantity discounts.

26

Macy’s does not depend on its suppliers and has no long-term

commitments with any suppliers. That is why they do not get more than 5% of

their merchandise from one supplier. Macy’s overpowering market share gives

them the ability to dictate quantities and prices to their suppliers.

Low Input Cost

Operating with minimal cost shows that the company is operating

efficiently. Macy’s hires extra employees around holidays to help out with the

high demand. This prevents these workers from being on the payroll all year,

which keeps wage costs low. With the recent merger of Macy’s and May’s, they

“acquired about 500 department stores and approximately 800 bridal and

footwear stores,” (Macy’s 10-K). This puts a large strain on management and

therefore makes it easy to mismanage funds in terms of employees or inventory.

Macy’s has computer systems to track inventory to avoiding accruing excess

inventory or essentially, waste.

“Macy’s realized more than $175 million in cost savings in 2006 and

expects to realize at least 450 Million in cost savings in 2007 due to the

consolidation of central functions and division integrations,” (Macy’s 10-K). The

taking over of other companies, like May’s, has lead to great price savings for

Macy’s overall. They are able to adopt the good practices that other companies

had before the take over and merger.

In striving to provide quality customer service to its customers, Macy’s

realizes that they need to retain the employees they currently have. This will lead

to lower employee turnover, which will allow Macy’s to save money needed to

spend on training new employees.

Macy’s also invested in a centralized organizational system for ordering

merchandise. Having the same decision implemented in all of their other stores

enhances uniformity while ensuring the same strategies and decisions are being

implemented in all other stores.

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Low Cost of Distribution

When a firm owns its distribution centers, warehouses, and trucks it

reduces distribution costs. This gives them the ability to apply those resources

elsewhere. Macy’s has distribution centers and warehouses that cut distribution

costs significantly.

Superior Product Quality & Variety

The high-end retail industry is all about quality. Customers will not pay

high prices if they are not assured of getting a quality product. Macy’s is no

exception to this. Macy’s have taken pride in keeping up with all changes in

fashion trends. Some of the customers, especially women and children, will go to

a different store to shop if the new trend they are looking for is not available at

the store. Macy’s has built up strong relationships with designers which enables

them to stay ahead of changes in fashion and keep their customers happy.

Superior Customer Service

The customers are the reason for any firm’s success, therefore, it is

important to have the customers’ needs met in order to attract and retain new

customers. Macy’s has done this by simplifying prices to make the shopping

experience easy and better for all customers. They have different sections for

mark downs and clearly label sale prices on items. “Macy’s has created a

customer loyalty program, called Star Rewards,” (Macy’s 10-K). This program

provides special offers and discounts to customer with the Macy’s credit cards.

This not only rewards the customers, but also encourages spending. The credit

cards increase sales, normally resulting in customers buying items that they

otherwise may not have had the funds for.

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Investment in Brand Image

In the high-end retail industry, fashion changes relatively quickly and the

companies have to keep up with these changes in order to stay competitive.

Macy’s has done a good job of keeping up with emerging designers and

maintaining relationships with other brand retailers. A result of this practices the

sustaining of loyal customers. They achieve this through strong private label

merchandising, which has created a loyal following of certain designer items

offered exclusively at Macy’s.

Conclusion

Macy’s has positioned itself in the high-end industry as a major player.

They now only strive to provide high quality products but, they are also trying to

emerge as a cost leader in the industry. Macy’s has successfully done so by

implementing tight cost control systems that truly work for them, like having a

centralized organization system. They have also installed an inventory system to

avoid having excess inventory at any one time. Since Macy’s is a high-end

industry, their customers expect to pay high prices on products because they

know they are getting high quality goods, in the latest designs.

If Macy’s successfully implements the cost control measures, while

producing efficiently, they will enjoy high profits because they can still charge

the high prices on well-known brand names.

29

Analyzing Accounting

An accurate accounting analysis is vital to both the firm and the public,

because it shows the true financial health of the firm. Investors and

shareholders will rely on an accounting analysis for to help them make informed

decision on whether or not to invest in the company, and to know what to

expect in the future. It is assumed that the firm gives correct information in

their accounting disclosure, but through careful examination this may not always

the case.

The structure of an accounting analysis consists of six steps. The first is

to identify the key accounting polices associated with the firm. These key

policies will be directly linked to the key success factors of the firm. The second

step is to assess the degree of potential accounting flexibility. This is where the

firms identify how much “wiggle” room they have within the limits of GAAP. The

next step is to evaluate the actual accounting strategy the firm implements. This

is where the level of disclosure in the financials is used to determine how

conservative or aggressive the company is in its accounting methods. The fourth

step is to evaluate the quality of disclosure, looking at both a qualitative and

quantitative analysis of the firm. The fifth step is to identify any potential “red

flags” that may arise. The sixth and final step is to undo accounting distortions.

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Key Accounting Principles

To be successful in the high end retail industry, a firm must have a good

mixture of cost leadership and product differentiation. The ability to cut cost,

while providing a high quality product is essential. Macy’s key accountings

principles reflect these needs because they are directly linked to their six key

success factors: economies of scale and scope, low input costs, low cost of

distribution, superior product quality and variety, superior customer service, and

investment in brand image.

Capitalized and Operating Leases

One of the most influential accounting principles comes from a firm’s

decision on using operating lease versus capital leases. Operating leases allow

the firm leasing the property to avoid the risk associated with owning the

property and are able to treat it as an operating expense, reported on the

income statement. This allows the firm to keep this information off of their

balance sheets. Capital leases are less appealing because they are presented on

the balance sheet, and above all, increase the amount of liabilities shown on the

balance sheet. Macy’s, like many of the other high-end retail stores, deal

primarily with operation leases. For example, in 2006, Macy’s had operating

lease obligations of $225 million as compared to only $10 million in capitalized

leases. Choosing to use all operating leases will drastically lower the amount of

liabilities shown on the company’s financials. This type of accounting method can

misrepresent the financial strength of the firm by distorting the financial

statements. It allows the firm to appear cost efficient, which is important to a

highly competitive market, yet may not always be true of the company.

However, Macy’s helps to prevent this by disclosing the future operating and

capital lease obligations for the next five years, and the remaining obligation

after five years, in the footnotes of its financial statements.

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Future Lease Commitments

Year Capitalized Leases

Operating Leases Total

2007 $10 $225 $235 2008 $9 $211 $220 2009 $9 $193 $202 2010 $8 $181 $189 2011 $7 $166 $173 After 2011 $45 $1,826 $1,871 Total Lease Payments $88 $2,802 $2,890

*table derived from Macy’s 10-K Goodwill

When a firm purchases another firm it usually pays more than the book

value of the company. This is known as goodwill and is shown on the balance

sheet as an intangible asset. Macy’s chooses to review its goodwill on an annual

basis for possible impairment. This review is done by the management, and is

subject to many judgment based decisions. Through taking into consideration

sales, gross margin, and expense growth rates, the management makes a

decision on how much impairment to take on these assets. These assumptions

made by the management can greatly affect the amount of goodwill shown on

the balance sheet. Because they do not disclose the details of these decisions

used to impair its goodwill, there is lots of room for flexibility.

Advertising Disclosure

As a high end department store, Macy’s relies greatly on advertising for its

success. Because of this, they incur a very high level of advertising costs.

However, Macy’s chooses to disclose the totals for their advertising expenses in

the “notes to consolidated financial statements.” It is also to note that because

it sells other “vendors” merchandise, they receive allowances for advertising.

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These arrangements with the “vendors” are typically informal and for a short

period of time (one year or less). The allowances show up in the notes to

consolidated financial statements as well. For example, Macy’s had $1,171

million in advertising costs in 2006 not considering the $517 million in advertising

allowances in 2006. These allowances make up a considerable amount of the

total advertising costs and must be accounted for properly.

Pension and Retirement Plans

From an industry standpoint, it is extremely important to keep costs low,

in order to pass on the savings to its customers. Being able to cut cost, when

available, can increase net income considerably. Macy’s recently raised its

pension discount rate .15% from 5.70% in 2005 to 5.85% in 2006. This

increase in the discount rate results in a decrease in the pension expense

recognized on the financial statements each year. This will allows Macy’s to pass

on these savings to the customers. However, this is offset slightly by two large

“voluntary” contributions to the pension plans in 2005 and 2006 of $136 million

and a $100 million respectively. Macy’s uses the accrual method when it is

recognizing pension expense, by estimating the remaining service period of the

employee to collect the benefit.

Conclusion

Being able to identify the key accounting principles is very important

because it is the first step of the method for a structured accounting analysis.

Macy’s must be able to link its key success factors (economies of scale and

scope, low input costs, low cost of distribution, superior product quality and

variety, superior customer service, and investment in brand image) to its key

accounting principles. Macy’s ability to focus on the accounting methods of

capital and operating leases, goodwill, advertising disclosure, and pension plans,

is vital to the profitability and success of the firm.

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Degrees of Accounting Flexibility

Capital vs. Operating Leases

Macy’s has tremendous flexibility in accounting principles when dealing

with capital or operating leases. An operating lease is just that, it is a lease for

operating a business for the terms of the contract. When the contract or lease is

up then they have the option of renewing the lease or giving up use to the

facility. Companies use this type of lease to keep the expense off the balance

sheet. Ownership does not transfer from lessor to lessee, therefore only

reflecting the expense on the income statement as an operating expense.

Manipulation can occur using operating leases because liabilities can be severely

understated, which leads to expenses being understated. If expenses are being

understated that would in turn cause net income to be overstated which would

lead to retained earnings being overstated. This could be misleading because it

overstates retained earnings and would entice investors to invest more money

under false pretenses.

A capital lease, on the other hand, does affect the firm’s balance sheet. It

is listed on the balance sheet as both a liability and an asset, lease payment and

an increase to PPE respectively. This is why Macy’s chooses to deal mainly with

operating leases. For example, Macy’s had $225 million operating leases

compared to only $10 million in capitalized leases. However, Macy’s can benefit

from capital leases in many ways such as depreciation and reducing interest

expense. Macy’s assumes risks when dealing with capital leases, for example

taxes and payments for the property, capital leases can lead to increased equity

because payments are being made toward ownership. Most high-end retail

department stores option to use operating leases because the expenses

associated with capital leases are recognized sooner than if you were to use an

operating lease.

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Pensions

Pension plans are another area where Macy’s can show flexibility. “The

Company has a funded defined benefit pension plan and an unfunded defined

benefit supplementary retirement plan” (the “Pension Plan”). “The company

funds this plan using SFAS 187,” (Macy’s 10K, pg. 24). Macy’s keeps these plans

on the books as long-term liabilities. Pensions to be paid are based on estimates

such as length with the company, how long they will live after retiring, the

expected rate of return on the investment and actual contribution towards the

plan by the employee. If estimates are not accurately done, then net income will

be overstated or understated based on the mistake made. Estimates must be

done accurately based on the present value of the liabilities. Although funding

requirements do exist, they are due to government regulations not SFAS 87 or

158. At February ’07 the company had 2 big unrecognized losses from the

pension plans totaling $371 million, these loses will be recognized as a

component of pension expense in future years in accordance with SFAS 158

(Macy’s 10K, pg 24).

Advertising Disclosure

How Macy’s discloses and accounts for its advertising costs leaves

room for flexibility within GAAP. Macy’s chooses to disclose its total advertising

costs for the year in the notes to consolidated financial statements. For 2006

Macy’s had $1,171 million in advertising costs. However, they also have

allowances that they receive from venders which totaled $517 million in 2006.

This is a very significant number, and it is accounted for differently than the

typical advertising costs. Macy’s chooses to credit these allowances to the costs

of sales when the transaction (sale) takes place. Where the flexibility comes in is

when and how they account for their normal advertising costs (i.e. radio and TV

ads, promotional events, etc). They can choose either to expense the costs as

incurred, or over a period of time. Having this choice allows them to choose

when the advertising expense will show up on the income statement.

35

Actual Accounting Strategy

When a company reports their financial information each year, they can

take either a conservative, aggressive, or a combination accounting strategy.

Due to the flexibility provided by GAAP, corporations may adjust their income

statement or balance sheet to make it seem more appealing to investors in an

effort to inflate stock prices. This approach is referred to as an aggressive

strategy. On the other hand, some firms take the opposite strategy and are more

conservative in their approach to reporting financial information.

After reviewing Macy’s financial statements from recent years, it is

apparent that they use a mixture of these accounting strategies. The reported

net income for Macy’s Inc. was average compared to its competitors. This

reveals that they are not trying to inflate their figures in order to appear better

than their competitors. However, Macy’s recent merge with Federated may hint

towards an aggressive strategy. Often firms will merge with other corporations in

order to hide or cover up certain financial information that may be unattractive

to investors. The process of merging with a similar corporation will allow Macy’s

to perhaps combine their financial data with Federated in order to make it seem

more pleasing to investors.

Similar to many of Macy’s competitors, they offer a retirement pension

plan to employees that have worked for the company for over one year. These

retirement expenses along with stock based compensation expenses have

severely impacted the Selling, General, and Administrative Expenses portion of

the Income Statement. The SG&A Expenses have increased rapidly over the past

few years. This systematic reporting of these vague expenses reveals that Macy’s

is leaning towards a conservative accounting strategy for this particular instance.

36

In the departmental retail industry it is extremely common for these

companies to utilize operating leases. Macy’s uses operating leases to reduce the

amount of risk related to owning property and records it as an operating expense

on the income statement. This will often lead to financial information being

misinterpreted. In addition, the ownership of the property does not transfer from

the lessor to the lessee. Therefore, there is no impact on the balance sheet. This

may cause the assets and liabilities section to be much different than if they did

not have operating leases. Furthermore, this reduces the amount of disclosure of

information that Macy’s reveals to investors because they are not showing it on

their balance sheet.

Capitalization of operating leases using 9.9% discount rate

year counter raw pmt Pv Factor Pv pmt BB Int Pmt PrincipalEnding B

2007 1 225 0.9099 204.73 1455.31 144.08 225 80.92 1374.392008 2 211 0.8280 174.70 1374.39 136.06 211 74.94 1299.452009 3 193 0.7534 145.40 1299.45 128.65 197 68.35 1231.102010 4 181 0.6855 124.08 1231.10 121.88 181 59.12 1171.972011 5 166 0.6238 103.54 1171.97 116.03 166 49.97 1122.002012 6 181.8 0.5676 103.18 1122.00 111.08 181.8 70.72 1051.282013 7 181.8 0.5164 93.89 1051.28 104.08 181.8 77.72 973.552014 8 181.8 0.4699 85.43 973.55 96.38 181.8 85.42 888.142015 9 181.8 0.4276 77.73 888.14 87.93 181.8 93.87 794.262016 10 181.8 0.3891 70.73 794.26 78.63 181.8 103.17 691.092017 11 181.8 0.3540 64.36 691.09 68.42 181.8 113.38 577.712018 12 181.8 0.3221 58.56 577.71 57.19 181.8 124.61 453.102019 13 181.8 0.2931 53.29 453.10 44.86 181.8 136.94 316.162020 14 181.8 0.2667 48.49 316.16 31.30 181.8 150.50 165.662021 15 181.8 0.2427 44.12 165.66 16.40 181.8 165.40 0.26

37

The above diagram shows the operating lease payments. Macy’s 10k has

operating lease schedule from 2007 till 2011. We used an average for 2012 till

2021 because Macy’s stated that the rest of the lease payments would be

distributed till 2087. The beginning balance in 2007 of 1455.31 is how much the

liabilities and assets have been understated by. This is 4.5% of total assets and

8.41% of total liabilities. The discount rate of 9.9% was reached at by trial and

error method from the lease schedule.

Balance sheet 2006, with and without lease adjustments original adjusted millions millions ASSETS Current assets: Cash and cash equivalents 1,211 1,211 Accounts receivable 517 517 Merchandise inventories 5,317 5,317 Supplies and prepaid expenses 251 251 Assets from discontinued operations 126 126 Deferred income tax assets Total current assets 7,422 7,422 Long-term assets: Capital lease rights 1,455 Net property and equipment 11,473 11,473 Goodwill 9,204 9,204 Other intangible assets, net 883 883 Other assets, net 568 568 Total Non-Current Assets 22,128 23,583 Total Assets 29,550 31,005 LIABILITIES AND SHAREHOLDERS EQUITY Current liabilities: Short-term debt 650 650 Accounts payable and accrued liabilities 4,944 4,944 Income taxes 665 665 Deferred income taxes 52 52 Liabilities of discontinued operations 48 48 Total current liabilities 6,359 6,359 Long-term liabilities: Capital lease obligation 1,455

38

Long-term debt 7,847 7,847 Deferred income taxes 1,728 1,728 Other liabilities 1,362 1,362 Total Non-current Liabilities 10,937 12,389 Total liabilities 17,296 18,748 Stockholders Equity Dividends 274 274 Common Stock 6 6 Additional paid-in capital 9,486 9,486 Retained earnings 6,375 6,375 Treasury Stock -3,431 -3,431 Accumulated other comprehensive income (loss) -182 -182 Unearned Restricted Stock Total shareholders' equity 12,254 12,254 Total Liabilities and Shareholders' Equity 29,550 31,005

Above is Macy’s 2006 balance sheet including and excluding the capital

leases. By Macy’s using operating leases they are understating their liabilities by

almost 1.5 billion dollars, therefore misleading the value of the firm.

As one can see, Macy’s Inc. utilizes both aggressive and conservative accounting

strategies. For the most part, Macy’s is fairly straightforward about disclosing its

financial information, but there are some circumstances in which this information

can be misinterpreted.

39

Quality of Disclosure

Qualitative

The 10-K is the main source of information disclosed by a company on

how well or bad they have performed in the previous year. Investors and

analysis rely on this source of information so that they evaluate the company

and having an idea whether to invest in the company or not.

Macy’s disclosure on their 10-K is moderate; they excel in some areas and

do a terrible job in other areas. We think that they have because worse in the

management section of the 10-K, for example in the 2002 10k they state that

sales reduced from 16,638 million to 15,651 million and then go on to say why,

because of the events of September 11 and the closing of Stem’s. But when you

get to the 2006 10-K they do not talk about increase in sales.

Macy’s does a good job in showing information about common stock.

Low High Dividends

1st quarter 32.37 39.21 0.1250

2nd quarter 32.57 39.69 0.1275

3rd quarter 33.52 45.01 0.1275

4th quarter 36.12 44.86 0.1275

This kind of information is vital to shareholders and investors because it

shows how the stock prices faired in every quarter. However they do not explain

why there was as increase in the 4th quarter.

40

Quantitative

Quantitative analysis is the use of ratios to explain or backup the

performance of a company. Macy’s will be evaluated using sales manipulation

diagnostic ratios and expensive manipulation diagnostic ratios. These ratios will

be used to see if Macy’s numbers add up to what there are supposed to and

eventually identify potential red flags. Since we not only evaluate Macy’s number

but also for the companies in the industry it will help us identify industry trends.

Sales Manipulation Diagnostics

These diagnostic ratios include: net sales/cash from sales, net sales/net

accounts receivable, net sales/inventory, net sales/unearned revenues, net

sales/warranty liabilities. The key measurement in each of theses ratios is the

denominators’ relation to net sales.

Net sales / Cash from sales

0.000

0.200

0.400

0.600

0.800

1.000

1.200

2002 2003 2004 2005 2006

Net sales/ cash from sales

Macys

Nordstrom

Saks

Dillards

Industry

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The net sales/cash from sales ratio is calculated by dividing the net sales

by (the change in accounts receivable plus the net sales). This ratio should

ideally be equal or close to 1. This ratio tells us that the company is backing up

all they’re sales with money. If the ratio keeps increasing, it means that the

company has lots of sales that are not backed up by any money.

Dillard’s shows a deviation in 2004 because they were using the private

label credit card program. “The private label credit card plan is a plan established

for the primary purpose of providing customer financing for goods and services

purchased from a company,” (Onecle.com). As a result of the private label credit

cards, Dillard’s does not show the accounts receivable for the purchases on those

credit cards.

Macy’s net sales/cash from sales ratio was above 1 in 2002, meaning that

they had a lot of sales not back up by money. “In 2002, Macy’s sold off operation

of Fingerhut companies including Arizona mail order, Figi’s, and popular club plan

business conducted by Fingerhut’s subsidiaries,” (Macys 10-K 2003).

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Net sales / Net accounts receivables

This ratio is calculated by diving net sales by accounts receivable. Saks

only had accounts receivable for 2002 and 2003, meaning they eliminated their

credit cards and operated on a straight cash basis. Dillard’s however, showed a

drastic increase in the ratio, which is due to the sale of its “credit cards to GE

fiancé charge,” (Dillard’s 10-K). As a result, their accounts receivable reduced on

the books, thus a high ratio. Macy’s jolt increase from 2005 to 2006 is explained

by their acquisition of May’s company. All of their sales were backed up with

cash.

0

2

4

6

8

10

12

14

2002 2003 2004 2005 2006

Net sales / Net accounts receivables

Macy's Nordstrom Saks

Dillard’s

Industry

43

Net sales / Inventory

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

2002 2003 2004 2005 2006

Net sales/inventory

Macy's

Nordstrom

Saks

Dillards

Industry

This ratio is calculated by dividing the net sales by the inventory. It

evaluates how well a firm uses its inventory to generate revenue. All of the

companies appear to stay very consistent in turning over their inventory. If the

ratios start increasing rapidly it would signify that sales are increasing, but

inventories are decreasing. This would be an indication of manipulation of sales

because there is no way you can increase sales and have nothing to sell.

44

Net sales / unearned revenue

This ratio is calculated by dividing net sales by unearned revenue.

Unearned revenue is when a service or a job is provided and payment is received

at a later date. In the high-end retail industry, sales are backed up by cash of

accounts receivables. Unearned revenue can be a way for a company to

overstate their sales and make it seem like they are doing better than they

actually are.

2006 2005 2004 2003 2002Macy's 39.26 34.82 35.93 37.04 39.17Dillard's 128.16 126.01 N/A N/A N/A Saks N/A N/A N/A N/A N/A Nordstrom N/A N/A N/A N/A N/A

Net sales / warranty liabilities

“Warranty is an obligation that an article or service sold is factually stated

or legally implied by the seller, and that often provides for a specific remedy such

as repair or replacement,” (Wikipedia). The high-end retail industry does not

offer warranties; the only warranties are backed directly by the manufacture.

45

Sales Manipulation Diagnostics

Net sales / cash from sales 2002 2003 2004 2005 2006

Macy’s 1.121 1.038 1.018 1.014 1.042 Nordstrom 0.996 1.010 0.981 1.002 0.999

Saks 1.008 1.005 Dillard’s 1.0190 1.0344 0.9811 0.8640 1.0004 Industry 0.784 1.021 0.993 0.96 1.013

Net sales / Net accounts receivables

2002 2003 2004 2005 2006 Macy's 6.579 5.241 4.751 4.494 8.878

Nordstrom 8.066 7.878 10.242 11.045 12.075 Saks 4.834 4.562

Dillard’s 7.586 5.912 6.378 Industry 6.766 5.898 7.124 7.7695 10.477

Net sales / inventory

2002 2003 2004 2005 2006 Macy's 4.636 4.595 4.748 4.923 4.101

Nordstrom 6.334 6.269 7.200 7.775 8.078 Saks 0.732 0.733 0.659 0.633 0.508

Dillard’s 5.221 4.962 4.655 4.344 4.194 Industry 4.231 4.140 4.316 4.419 4.220

Net sales / unearned revenue 2002 2003 2004 2005 2006

Macy’s 39.17 37.04 35.93 34.82 39.26 Nordstrom N/A N/A N/A N/A N/A

Saks N/A N/A N/A N/A N/A Dillard’s N/A N/A N/A 126.01 128.16

Expense Manipulation Diagnostics

Expense diagnostic ratios, much like revenue diagnostic ratios, provide

ways for analysts and investors to check the numbers reported in a firm’s

financial statements. Expense diagnostic ratios include: Asset Turnover, Change

in CFFO/OI, Change in CFFO/NOA, Total Accruals/Change in Sales, Pension

Expense/SG&A, and Other Expenses/SG&A. In addition, the expense ratios

indicate how well a firm is managing their expenses.

46

Asset turnover

The asset turnover ratio is computed by dividing net sales by the average

of the total assets from the previous and the current year. This ratio is useful

when determining the amount of sales that are generated from each dollar of

assets. Companies with low profit margins tend to have high asset turnover,

while those with high profit margins have low asset turnover. In the retail

industry, companies experience high turnover ratios. This is mainly because of

competitive pricing between stores. (insvestopedia.com) In general, asset

turnover for the industry tends to move together. However, in 2005 there was a

large decline in Macy’s asset turnover compared to its competitors. This is

because of the acquisition of May’s Department Stores, which increased Macy’s

total assets substantially.

47

Cash Flows from Operating Activities / Operating Income

Cash flows from operations refers to the amount of cash a company

generates from the revenues it brings in (wikipedia.org). On the balance

sheet, this is calculated by subtracting a firms expenses from its revenues.

Operating income, also known as EBIT (earnings before interest and taxes),

is found on the income statement. CFFO/OI indicates how a firm’s operating

income matches the cash generated from operations. Looking at the graph,

we can see that CFFO/OI for the industry has been a bit volatile. However,

Macy’s is relatively stable. Macy’s showed a slight decrease in 2003, but this

was due to the closing costs associated with their purchase of Stern’s

Department Store.

48

Cash Flows from Operating Activities / Net Operating Assets

CFFO, again, is the cash that is generated from operating activities and can

be found on the balance sheet. Operating assets would include PPE.

Therefore, CFFO/NOA is a measure of how well a company is utilizing their

PPE in respect to their cash flows from operations. An increase to this ratio

indicates an increase in the firm’s utilization of PPE.

Looking at the graph we can see Macy’s has a high CFFO/NOA, when

compared to the industry. The sharp increase in 2005 is a result of Macy’s

acquisition of May’s Department Stores. With the acquisition of new PPE,

Macy’s experienced an increase in their CFFO. From 2005-2006, we can see

that Macy’s CFFO has been increasing at a higher rate than their PPE. This is

reflected in the increase of Macy’s CFFO/NOA.

49

Total Accruals / Change in Sales

In accrual basis accounting, an accrued expense is a liability resulting from

an expense for which no invoice or other official document is available yet.

Similarly, accrued revenue is an asset resulting from revenue for which no official

document was issued yet (wikipedia.com). Accrual based accounting provides a

more accurate view of a firm’s financial standing at any given time because it

takes into account expenses and revenues that have not actually been paid or

received.

When compared to the industry, Macy’s accrual/change in sales is a bit

above average. This could indicate that Macy’s tends to sell more merchandise

on credit, as opposed to cash sales. However, in the high-end retail industry, it is

common practice for firms to offer company credit cards like a Macy’s card or a

Dillard’s card.

50

Expense Manipulation Diagnostics

M 2002 2003 2004 2005 2006 CFFO/OI 1.2428 0.8697 1.1857 1.0764 0.8045 CFFO/NOA 0.3847 0.3287 0.4455 0.4696 0.7632 Asset Turnover 1.0389 1.047 1.053 1.1299 0.9319 Total Accruals/Change in Sales -0.3433 -0.0724 -0.1859 -0.1658 -0.0779 Pension Expense/ SG&A

JWN CFFO/OI 2.8408 1.4687 1.7162 1.0989 1.0573 CFFO/NOA 0.3738 0.2317 0.4077 0.4928 0.6206 Asset Turnover 1.4716 1.4671 1.5164 1.5723 1.6213 Total Accruals/Change in Sales -0.1678 -0.1039 -0.17 -0.1054 -0.1071 Pension Expense/ SG&A

SKS CFFO/OI 3.5832 1.1853 2.0243 1.8475 0.9307 CFFO/NOA 0.3804 0.2459 0.4324 0.315 0.2352 Asset Turnover 1.2587 1.2885 1.3114 1.3756 1.3918 Total Accruals/Change in Sales -0.269 -0.1894 -0.2591 -0.1844 -0.107Pension Expense/ SG&A

DDS CFFO/OI 2.1638 2.2386 1.4198 CFFO/NOA 0.3264 0.1591 0.256 0.4439 0.368 Asset Turnover 1.1426 1.1506 1.1613 1.2441 1.349 Total Accruals/Change in Sales -0.2482 -0.349 -0.2015 -0.2079 -0.1213 Pension Expense/SG&A

51

Potential “Red Flags”

Financial Statements are constructed by people and people make

mistakes. These mistakes are identified as “red flags” to investors. It is not

always clear whether a “red flag” is a result of a common human error or an

attempt at something much more serious, such as fraud. Therefore, it is

essential to catch every extreme fluctuation in the financials that may seem

questionable.

Macy’s 10-K report appears to be very thorough. The final forty-seven

pages are detailed notes of the consolidated financial statements. Included in

these notes is an explanation for an accounting error from their 2004

statements. “During 2004, the Company reviewed its accounting for leases in

accordance with the accounting policies set out above. As a result of this review,

certain errors were identified and were corrected in the fourth quarter of 2004.

Depreciation expense was increased by $42 million and rent expense was

decreased by approximately the same amount, resulting in an insignificant

impact on selling, general and administrative expenses.

Additionally, property and equipment, net was increased by $65 million

and accounts payable and accrued liabilities were increased by approximately the

same amount” (Macy’s 10-K). This is just one example of how Macy’s shows the

ability to go into great detail in their statements and allow investors to easily

understand the changes that they make. Having this much attention to detail of

their past statements also forces them to focus more when they are preparing

their current statements. High attention to detail is a good attribute for Macy’s to

have while preparing their statements because it reduces mistakes (and potential

“red flags”). Dramatic over/understatements of sales and expenses are common

things to key in on while searching for “red flags.” Macy’s has two areas in their

financials that raise question about validity. The 2002 sales / cash from sales

ratio and the 2006 net sales ratios could both be marked as potential “red flags.”

52

Undo Accounting Distortions

As mentioned earlier, one potential “red flag” found in Macy’s financial

statements is from 2002. The sales/cash from sales ratio for 2002 was

abnormally high, insinuating a potential problem. There were no cash receipts to

explain the overstatement of sales for this ratio. However, since the ratios

appeared to be normal for every year after that, we believe that the problem

was discovered and already resolved.

Another potential “red flag” found in the Macy’s financial ratios deals with

the net sales ratios for 2006. The net sales / net accounts receivable ratio

doubles between the years 2005 and 2006. Meanwhile, net sales / unearned

revenue is the other abnormal ratio for this year, as it is constant around 7 for

the previous few years and then jumps to over 12 in 2006. An explanation for

this behavior is a dramatic increase of sales during this time period. However, if

the large increase in net sales was truly the reason for this ratio influx, all of the

net sales ratios would be inflated. This is not the case. Only half of the net sales

ratios seem to be abnormal. The net sales / changes in cash collectibles and net

sales / inventory ratios seem to be perfectly in line with their previous years’

trends. This poses the question, which trends are incorrect?

A closer look at the ratios indicates that the trends are not extremely

abnormal due to net sales, but because of the other components. The net

accounts receivables and the unearned revenues decreased over the year

instead of increasing, as one would anticipate. To double-check this theory, we

look at inventory and cash collectibles to confirm that they both increased in a

similar fashion as net sales. It also is appropriate for the net accounts receivable

and unearned revenue to flow together. Since the net accounts receivables

decreased, it would be expected that the unearned revenue liability would also

decrease.

53

Conclusion

Therefore, we can conclude that there is nothing wrong with the financial

ratios for Macy’s for 2006; they simply just had more cash transactions. After

looking deep into Macy’s financial statements, it is apparent that each of the

potential “red flags” is easily explained and in fact, normal.

54

Ratio Analysis

The primary goal of ratio analysis is to measure the performance of a

company relative to its main competitors in a particular industry. The value of a

firm is determined mainly by its profitability and growth. In addition, ratios are

useful for evaluating how the firm will perform in the future. The three main

types of ratios are liquidity, profitability, and capital structure. Ratio analysis also

provides useful information on how key components of a company’s financial

statement relate to one another.

Liquidity Analysis

Liquidity ratios are used to show how easy (or difficult) it is for a firm to

pay off short-term debt. Generally, a firm with a higher ratio value will be able to

cover short-term debts with a larger margin of safety than a company with a

smaller ratio (www.investopedia.com). The most common liquidity ratios that we

will discuss in regards to Macy’s include: Current Ratio, Quick Asset Ratio,

Inventory Turnover, Days Supply Inventory, Receivables Turnover, Days Sales

Outstanding, and Working Capital Turnover. It is important for investors to be

educated on these ratios to better understand the companies that they are

investing in. The higher the ratio, the better off the investor is.

Current Ratio

The current ratio is a measurement of a company’s ability to pay short

term obligations, such as loans and lease payments. The current ratio is

favorable for a company when it is greater than one and less than two. Macy’s

Current Ratio is the lowest in its industry. This illustrates that Macy’s is not nearly

as liquid as the other companies that it is competing against. Another trend to

take notice of in this graph is Macy’s yearly trend. Not only are they the least

liquid in the industry, but they are on a downward slope, getting less liquid each

55

year. Investors should beware of Macy’s increasing dominance of current

liabilities over its current assets.

Quick Asset Ratio

The quick asset ratio is a measure of how effective a company is in paying

off its current debt obligations by using its most liquid and current assets. The

quick asset ratio is also a good indicator of a company’s short term liquidity. In

order for this ratio to be beneficial to the company, the ratio must be greater

than or equal to one. This formula can be calculated by taking the sum of the

quick assets: cash, securities, and accounts receivable, and then dividing this by

the current liabilities.

Macy’s quick asset ratio has declined sharly from 2004 to 2006. In 2002

Macy’s quick asset ratio was in stable and good financial condition, but has

recently decreased due to either an increase in current liabilities or a decrease in

quick assets. Furthermore, Macy’s quick asset ratio was close to the industrial

average from 2002 to 2004, but has fallen far below this average in 2006. This is

definitely an area that Macy’s upper management should work on improving.

56

Quick Asset Ratio

0

0.5

1

1.5

2

Macy'sSaksDillardsNordstromIndustry Average

Macy's 1.05 1.09 1.02 0.62 0.33Saks 0.77 0.61 0.6 0.99 0.54Dillards 1.73 1.04 0.54 0.3 0.28Nordstrom 1.23 1.28 1.23 1.18 1.2IndustryA

1.24 0.98 0.79 0.82 0.67

2002 2003 2004 2005 2006

Receivables Turnover

The accounts receivable turnover ratio is an important measurement of

how efficient a company utilizes its assets, especially accounts receivable. It is

also a determinant of how effective the company is in collecting debt. The ratio

is computed by dividing the sales by the accounts receivable. The higher this

ratio, the more profitable it is for the company.

Macy’s accounts receivable ratio stayed about the same from 2002 to

2005, until it rose significantly in 2006 from 8% all the way up to nearly 52%.

With exception of 2006, Macy’s accounts receivable ratio stayed fairly close to

the industry average. When computing our accounts receivable ratios for our

competitors, we noticed that Saks did not report accounts receivable on their

balance sheet. Therefore, we did not include them in this ratio. The receivables

turnover ratio is extremely inconsistent in the high-end retail industry. The ratio

57

tends to fluctuate significantly from one year to the next. This ratio is not as

relevant in this industry compared to other ratios.

In addition, Dillard’s receivable turnover ratio was significantly higher

than all the other firms. Overall, it appears that Macy’s has a respectable

accounts receivable turnover ratio compared to its competitors.

Receivables Turnover

0

200

400

600

800

Macy'sSaksDillardsNordstromIndustry Average

Macy's 5.24 4.75 4.57 8.88 52.17Saks 0 0 0 0 0Dillards 5.91 6.38 780.08 603.70 726.69Nordstrom 7.86 10.24 11.04 12.07 12.5IndustryA

6.89 8.31 395.56 307.89 369.60

2002 2003 2004 2005 2006

Days Sales Outstanding

Days sales outstanding is a method of determining the amount of days it

takes for a company to collect revenue after a sale has been made. The smaller

this number, the better it is for the company because it means that they are

collecting revenue from their customers on a timely basis. This figure can be

higher for companies that sell products, which require payments over a long time

period.

After analyzing Macy’s and it competitors, there are several conclusions

that can be drawn from the data. For instance, from 2002 to 2005 Macy’s day’s

58

sales outstanding ratio was significantly higher than its competitors. However, in

2006 this number suddenly dropped by almost 34 days and fell below the

industrial average. This can be attributed to a policy change in the way Macy’s

collects revenue after a sale has been made. This substantial decrease in the

day’s sales outstanding has a favorable impact on Macy’s.

Days Sales Outstanding

0

20

40

60

80

100

Macy'sSaksDillardsNordstromIndustry Average

Macy's 69.66 76.84 79.87 41.1 7Saks 0 0 0 0 0Dillards 61.74 57.23 0.47 0.61 0.50Nordstrom 45.58 36.25 33.04 28.52 28.32IndustryA

53.66 46.74 16.75 14.56 14.41

2002 2003 2004 2005 2006

Inventory Turnover

“The inventory turnover ratio reveals how many times a company’s

inventory is sold and replaced over a period,” (www.investopedia.com). This

ratio is calculated by dividing the cost of goods sold by the inventory of a

company. The higher this ratio is the better because it means that inventory is

being sold and restored. Having a large amount of inventory can be harmful to a

company because as inventory sits in storage it can deteriorate. In addition, as

inventory accumulates, it will cause profits to decrease due to the seasonality of

59

this industry. For instance, as a company’s merchandise becomes outdated, the

prices for the products are discounted. Therefore, this negatively impacts the

profitability of a company.

Macy’s inventory turnover has been relatively low compared to its

competitors. However, this ratio has been gradually increasing for Macy’s over

the past five years, with exception to 2005.

Inventory Turnover

01

23

45

6

Macy'sSaksDillardsNordstromIndustry Average

Macy's 2.76 2.83 2.98 2.43 3.01Saks 2.86 2.59 2.64 4.64 2.3Dillards 3.30 3.17 2.90 2.78 2.84Nordstrom 4.26 4.43 4.95 5.11 5.32IndustryA

3.47 3.40 3.50 4.18 3.49

2002 2003 2004 2005 2006

Days Supply of Inventory

The days’ supply of inventory ratio is used to determine how many days

inventory sits in storage or on the shelves. This figure often varies depending on

the time of year, especially in the retail departmental industry. To calculate this

formula, you divide 365 days by the inventory turnover.

Macy’s days’ supply of industry in recent years has ranged from 121 days

to 150 days. This number is higher than the industrial average, but has not

60

necessarily been the highest during this time period. For instance, competitors

such as Saks and Dillard’s have also had high days’ supply of inventory.

Days Supply Inventory

0

50

100

150

200

Macy'sSaksDillardsNordstromIndustry Average

Macy's 132.25 128.98 122.48 150.21 121.26Saks 127.62 140.93 138.26 78.66 158.7Dillards 110.76 115.24 126.06 131.23 128.54Nordstrom 87.21 82.56 73.52 71.42 71.54IndustryA

108.53 112.91 112.61 93.77 119.59

2002 2003 2004 2005 2006

Working Capital Turnover

“The working capital turnover ratio is used to analyze the relationship

between the money used to fund operations and the sales generated from these

operations.” (www.investopedia.com) Working capital is current assets minus

current liabilities. In order to find the working capital turnover, you take sales

and divide it by working capital. “Therefore, a higher working capital ratio means

that the company is generating more sales than the amount of money that is

required to fund these sales.” (www.investopedia.com)

After evaluating Macy’s working capital turnover it appears that this ratio

has decreased drastically from 2002 to 2003 and then has leveled off. In 2006,

the working capital ratio for Macy’s was 4.34. Therefore, it is producing $4.34 in

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sales for every dollar of working capital. This particular number is the lowest out

of all of its competitors.

Working Capital Turnover

05

1015

2025

30

Macy'sSaksDillardsNordstromIndustry Average

Macy's 25.37 8.76 4.87 4.28 4.34Saks 5.26 5.62 5.65 7.45 7.58Dillards 3.53 4.50 6.03 7.54 7.13Nordstrom 5.09 5.38 5.77 6.2 6.4IndustryA

4.63 5.17 5.82 7.06 7.04

2002 2003 2004 2005 2006

Conclusion

After analyzing Macy’s liquidity ratios, it is apparent that Macy’s is not a liquid

firm compared to most of its competitors. For instance, it falls short of its

competitors in areas such as current ratio and quick asset ratio. In order for a

company to be successful in the retail industry it is important that they are as

liquid as possible.

Profitability Analysis

The main goal of profitability ratios is to determine how well a company is

performing in terms of profit. The profitability ratios consist of gross profit

margin, operating profit margin, net profit margin, asset turnover, return on

assets, and return on equity. We have analyzed Macy’s profitability ratios and

have compared them to it competitors.

62

Gross Profit Margin

The gross profit margin provides us with information concerning the

amount of money left over after accounting for the cost of goods sold. Gross

profit margin also functions as a tool to determine the amount of money left to

pay for future expenses. Therefore, it is a good indication of the financial health

of a company. Macy’s gross profit margin has remained fairly constant over the

last five years, ranging from 40 to 41%. For the most part, gross profit margin

should not change too much from year to year, unless there are drastic changes

that will severely impact the cost of goods sold. Furthermore, the gross profit

margin for Macy’s has been relatively higher than its competitors signaling that it

financial health is in good standing.

Gross Profit Margin

0.30.320.340.36

0.380.4

0.42

Macy'sSaksDillardsNordstromIndustry Average

Macy's 0.4 0.4 0.41 0.41 0.4Saks 0.37 0.38 0.38 0.37 0.39Dillards 0.34 0.32 0.33 0.34 0.34Nordstrom 0.34 0.35 0.36 0.37 0.37IndustryA

0.35 0.35 0.36 0.36 0.37

2002 2003 2004 2005 2006

Operating Profit Margin

The operating profit margin is a useful percentage, which reveals the

amount of money a company has remaining after paying for variable costs

associated with maintaining a business such as wages and raw materials. It is

calculated by dividing the operating income by net sales. This ratio gives us

63

information about the efficiency of a company and is also useful for determining

the amount of money a company has left over to pay for fixed costs. The higher

the percentage is for the gross profit margin, the more profitable it is for the

corporation. After analyzing Macy’s gross profit margin, it is apparent that their

gross profit margin is significantly higher than its competitors. However, over the

last few years the margin percentage has declined slightly.

Operating Profit Margin

-0.050

0.000

0.050

0.100

0.150

Macy'sSaksDillardsNordstromIndustry Average

Macy's 0.087 0.088 0.090 0.110 0.068Saks 0.039 0.038 0.03 0.034 -0.007Dillards 0.02 0.001 0.023 0.017 0.033Nordstrom 0.02 0.05 0.08 0.09 0.11IndustryA

0.027 0.030 0.044 0.047 0.045

2002 2003 2004 2005 2006

Net Profit Margin

The net profit margin is a valuable measurement when analyzing a

company. “It basically tells you the amount of profit a company makes from

every dollar of revenue it generates,” (invetopedia.com). It is calculated by

taking net income divided by sales. The net profit margin is a key indicator of

64

how profitable a company is in its particular industry. A high net profit margin is

always favorable because it reveals that the company is generating more profit.

If a company reports a low net profit margin it could be a result of price

competition between the company and its competitors.

Macy’s net profit margin has remained fairly consistent over recent years

and continues to be higher than most of competitors. The only competitor that

competes with Macy’s in regards to net profit margin is Nordstrom’s.

Net Profit Margin

-0.1

-0.05

0

0.05

0.1

Macy'sSaksDillardsNordstromIndustry Average

Macy's 0.05 0.05 0.04 0.06 0.04Saks 0.004 0.01 0.01 0.004 0.02Dillards -0.05 0.001 0.016 0.016 0.032Nordstrom 0.02 0.04 0.05 0.07 0.04IndustryA

-0.01 0.02 0.03 0.03 0.03

2002 2003 2004 2005 2006

Asset Turnover

Asset turnover is a ratio that evaluates how efficient a firm is in utilizing

its assets to generate sales. It is calculated by taking sales and dividing it by total

assets. In addition, it can also be a good indicator of pricing strategy. For

example, “If a company has high profit margins it will most likely have low asset

65

turnover,” (investopedia.com). In most cases the higher the asset turnover, the

more favorable it is for the company.

After analyzing Macy’s asset turnover ratio, it is obvious that their ratio is

significantly lower than it competitors. From 2004 to 2005 there was a notable

drop in asset turnover, but recovered slightly in 2006. This is one area of the

profitability analysis where Macy’s suffers compared to its competitors.

Asset Turnover

0

0.5

1

1.5

2

Macy'sSaksDillardsNordstromIndustry Average

Macy's 1.07 1.05 1.05 0.68 0.91Saks 1.29 1.3 1.37 1.55 1.16Dillards 1.19 1.19 1.32 1.37 1.41Nordstrom 1.46 1.45 1.54 1.57 1.78IndustryA

1.31 1.31 1.41 1.50 1.45

2002 2003 2004 2005 2006

Return on Assets

Return on assets is useful for determining how efficient a company is in

using its assets to generate income. Therefore, it is computed by taking the net

income from the current year and dividing by the total assets from the previous

year. This formula is also used to help calculate the sustainable growth rate and

the internal growth rate. The higher the return on assets, the better it is for a

company because they are earning more return on their investments.

66

Macy’s return on assets is average compared to the competitors in its

industry. It remained constant at 5% from 2002 to 2004 until it increased to 9%

in 2005. However, in 2006 it declined significantly all the way to 3%. As one can

see, the return on assets ratio for Macy’s has fluctuated in the past few years,

but it still remains competitive in it industry.

Return on Assets

-0.1

-0.05

0

0.05

0.1

0.15

Macy'sSaksDillardsNordstromIndustry Average

Macy's 0.05 0.05 0.05 0.09 0.03Saks 0.005 0.018 0.013 0.005 0.014Dillards -0.06 0.001 0.02 0.02 0.05Nordstrom 0.02 0.05 0.08 0.11 0.14IndustryA

-0.01 0.02 0.04 0.05 0.07

2002 2003 2004 2005 2006

Return on Equity

Return on equity is key indicator of how profitable a company is in regards

to the money that has been invested by shareholders. It is calculated by taking

the net income and dividing it by the total equity.

Macy’s return on equity figures are higher than the majority of it

competitors. This is extremely favorable to the company because this means that

they are efficiently using the funds invested by shareholders. Even though the

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return on equity percentage has fluctuated over the last five years, it still

remains near the top of its competition.

Return on Equity

-0.2

-0.1

0

0.1

0.2

0.3

Macy'sSaksDillardsNordstromIndustry Average

Macy's 0.15 0.12 0.12 0.23 0.07Saks 0.011 0.037 0.026 0.011 0.027Dillards -0.18 0.004 0.05 0.05 0.10Nordstrom 0.09 0.19 0.24 0.25 0.08IndustryA

-0.03 0.08 0.11 0.10 0.07

2002 2003 2004 2005 2006

Conclusion

After evaluating Macy’s profitability ratios, it is evident that they have

been extremely productive over the last five years. The only concern to the

company may be the asset turnover ratio. Otherwise, the company looks to be in

good financial shape and the future looks relatively optimistic for the company.

Capital Structure Analysis

The capital structure analysis is very important when valuing a firm,

because it shows how assets are financed through the combination of the debt

and equity on the balance sheet. We conducted our capital structure analysis by

calculating the Debt to Equity Ratio, Times Interest Earned, and the Debt Service

Margin for Macy’s as well as three of its competitors.

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Debt to Equity Ratio

The Debt to Equity Ratio is used to calculate the proportion of debt to

equity a firm uses to finance its assets. This is also known as “financial

leverage.” (www.investopedia.com). It is calculated by dividing the total

liabilities of a firm by the total owner’s equity. The D/E Ratio is extremely

important to investors and other lending institutions because it assesses the

credit risk of a firm.

For the past five years the high end retail industry has averaged a D/E

ratio between 1.27 and 1.67. Saks has shown the best D/E ratio in the past with

a low at .93, but they have seen some inconsistencies in the last few years with

their ratio jumping around. Both Dillard’s and Nordstrom’s have been able to

consistency decrease their D/E ratio over the last few years, which shows a

switch from debt to equity financing. Macy’s has stayed relatively consistent with

the industry average, only varying .10 over the last five years. They have been

69

able to lower their D/E ratio which shows they have been able to rely less on

debt financing, decreasing their credit risk, and making them a healthier firm.

Times Interest Earned

The Times Interest Earned ratio is very important to a firm because it

shows how well the firm's earnings are able to cover the required interest

expense. It is calculated by dividing Income from Operations by the Interest

expense for a given year. A financially healthy firm will have more than

sufficient income to cover its annual interest expense, resulting than a higher

than average ratio. A good benchmark for times interest earned ratio is 3 or

slightly better.

From an industry standpoint the average for the high end retail falls

between 2 and 4 which is a healthy average. Macy’s has one of best times

interest earned ratios, staying above 4 for the last 5 years. A high income from

operations and a relatively low interest expense allows Macy’s to cover its

interest expense with money left over to fund its other operations. Dillard’s had

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the lowest ratio due to exceptionally low operating income in 2003, and large

amounts of interest expense for all five years.

Debt Service Margin

A firm’s Debt Service Margin ratio is important because it measures the

capability of the cash provided by operations to cover the required annual debt

service. It is calculated by dividing the cash flows from operations of the current

year, by the notes payable of the previous year. The higher the margin of a

particular firm, the better the firm is able to retire its long term debt.

For our analysis, inconsistencies with Saks debt service margin caused our

industry average to vary to some degree. This was caused by extremely low

levels of notes payable for years 2001, 2003, and 2004. Because of this, the lack

accuracy of the industry average must be accounted for when comparing to

Macy’s. Nevertheless, Macy’s has the lowest debt service margin of the four

companies we calculated. This is a good indication that the firm is having

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difficulty covering its long term debt. However the industry trend from 2005 to

2006 was a decreasing debt service margin, while Macy’s saw a dramatic

increase (nearly quadrupling). Hopefully this is a tendency that will increase in

the years to come.

Internal Growth Rate

The internal growth rate (IGR) of a firm determines the sustainable growth

rate a firm can achieve through internal financing only. In other words, the firm

would be seeking to finance future projects with funds from internal operations

as opposed to financing with debt through banks or any other financial

institutions. Macy's IGR of 2.17% is relatively low the industry average of 8.62%.

However, the industry average is deceiving because Nordstrom's IGR has been

increasing at a very high rate over the past few years. Macy's actually fares

better than its competitors Dillard’s and Saks. This shows that Macy's has been

maintaining a steady balance between internal and external financing.

IGR

-10%-5%0%5%

10%15%20%25%30%

Macy'sSaksDillardsNordstromIndustry Average

Macy's 6% 4.50% 4.33% 3.55% 2.17%Saks 0.50% 2.00% -3.25% 0.50% -1.89%Dillards -5.80% -0.10% 1.60% 1.90% 4.20%Nordstrom 4.61% 13.24% 17.21% 21.36% 23.56%IndustryAverage

-0.23% 5.05% 5.19% 7.92% 8.62%

2002 2003 2004 2005 2006

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Sustainable Growth Rate

The sustainable growth rate (SGR) is the level growth a firm can maintain

without having to finance projects with new debt. This is very similar to the IGR

however, they differ in one respect and that is that the SGR is a measure of

sustainability. Macy's SGR is measured at 5.23%, which is low compared to the

industry average of 10.04%. The SGR is also a prime determinant of profitability

as well. This is because if the firm has to finance future projects through the use

of new debt they will have more obligations to pay and therefore making them

less profitable. Perhaps one reason that Macy's has been experiencing low IGR

and SGR rate is because of the acquisition of the May's Department Stores.

SGR

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

Macy'sSaksDillardsNordstromIndustry Average

Macy's 15.06% 11.03% 10.44% 8.70% 5.23%

Saks 1.01% 4.00% -7.35% 0.97% -4.39%

Dillards -15.40 -0.20% 4.70% 4.70% 10.00%

Nordstrom 5.70% 14.45% 19.12% 23.42% 24.50%

IndustryAverage

-2.90% 6.08% 5.49% 9.70% 10.04%

2002 2003 2004 2005 2006

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Conclusion

The analysis of a firm’s capital structure is very important because it

shows how assets are financed through the combination of the debt and equity

on the balance sheet. Compared to the industry, Macy’s Debt to Equity ratio was

right in line with the average. However, Macy’s was able to separated itself from

the competition in the times interest earned ratio because of its large cash flows

and low interest expenses. Where Macy’s faltered was in its Debt Service Margin.

The analysis showed that Macy’s is currently having trouble covering its long

term debt. These three different ratios, as compared to the industry averages,

show that Macy’s strength lies in keeping its interest expenses low while

increasing its cash flows.

Forecasting Financial Statements

Forecasting financial statements of a firm helps us see where the firm will

be in the future in terms of financial health. We evaluate historical values from

the firm’s current and past statements and use those to give us an idea of where

the firm will be in the future. To do this, we first put together Macy’s financial

statements from the past five years using the 10-K. Then, applied that data to

forecast out the next 10 years in order to see what kind of trend Macy’s would

have. We calculated an average of the important accounts and made a few

assumptions to forecast Macy’s income statement. To forecast the cash flow

statement, we took ratios of CFFO/NI, CFFO/SALES, and CFFO/OI and use the

ratio that shows the most consistency. We forecasted the balance sheet by using

Macy’s current ratio, asset turnover ratio, and the inventory turnover ratio.

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Income Statement

The income statement is considered the most accurate financial statement

because it has the least assumptions to be made. Since Macy’s released its 10-K

for the period ended February 03, 2007, they already have a 10-Q published for

the first quarter. We were able to use this document as a guideline while

forecasting.

We began by calculating an average of the sales growth over the last five

years, but when we did, we discovered there was a great level of inconsistency.

There was negative growth in 2002 and 2003, and then in 2005 and 2006,

growth shot up to 43% and 20%, respectively. Due to this, we felt that an

average would not depict an accurate measurement. Therefore, we researched

Macy’s 10-K to explain what happened to sales during those years. In 2005,

”Macy’s completed a merger and acquired May’s approximately 500 department

stores and approximately 800 bridal and formalwear stores,” (Macy’s 10-K). This

transaction explains the increase in sales. Since the merger is a one-time thing,

we do not expect sales to keep growing at a high rate of 43% every year. We

averaged the sales growth of the other firms in the industry and then made an

assumption more specific to Macy’s and came up with a sales growth of 10.71%.

75

Macys Inc

Actual Financial statements Forecast Financial Statements

2001 2002 2003 2004 2005 2006 ASSUME 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 As Reported Annual Income Statement 2/2/2002 2/1/2003 1/31/2004 1/29/2005 1/28/2006 2/3/2007 Millions Millions Millions Millions Millions Millions Net sales 15,651 15,435 15,264 15,630 22,390 26,970 10.71% $29,858 $33,056 $36,597 $40,516 $44,855 $49,659 $54,978 $60,866 $67,385 $74,602 $82,592 Total cost of sales 9,584 9,255 9,099 9,297 13,272 16,019 59.83% $17,864 $19,778 $21,896 $24,241 $26,837 $29,711 $32,893 $36,416 $40,316 $44,634 $49,415 Gross margin (loss) - - 6,165 6,333 9,093 10,773 40.17% $11,994 $13,279 $14,701 $16,275 $18,018 $19,948 $22,085 $24,450 $27,069 $29,968 $33,177 Selling, general & administrative expenses 4,801 4,837 4,824 4,933 6,980 8,678 31.42% $9,382 $10,386 $11,499 $12,730 $14,094 $15,603 $17,274 $19,124 $21,172 $23,440 $25,950 Operating income (loss) 1,104 1,343 1,341 1,400 2,424 1,836 8.52% $2,544 $2,816 $3,118 $3,452 $3,822 $4,231 $4,684 $5,186 $5,741 $6,356 $7,037 Interest on debt 321 301 257 231 438 563 Interest on capitalized leases -6 -6 -6 -5 -5 -6 Interest expense, gross 334 312 266 299 423 466 Interest expense 331 311 266 299 422 451 1.89% $564 $625 $692 $766 $848 $939 $1,039 $1,150 $1,274 $1,410 $1,561 Interest income 7 16 9 15 42 61 Income (loss) fr cont opers bef income taxes 780 1,048 1,084 1,116 2,044 1,446 Total income tax expense-federal 212 336 367 380 581 406 Total income tax expense-state & local 50 74 24 47 90 52 Federal, state & local income tax expense 262 410 391 427 671 458 Income (loss) from continuing operations 518 638 693 689 1,373 988 Discontinued operations, net of income taxes - - - - 33 7 Net income (loss) -276 818 693 689 1,406 995 3.74% $1,117 $1,236 $1,369 $1,515 $1,678 $1,857 $2,056 $2,276 $2,520 $2,790 $3,089 0.1071

Actual financial statements

Forecast Financial Statements Common Sized Income Statement 2001 2002 2003 2004 2005 2006 Average 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Sales growth Percent -1.380% -1.108% 2.398% 43.250% 20.456% 31.85% Net sales 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Total cost of sales 61.24% 59.96% 59.61% 59.48% 59.28% 59.40% 59.83% 59.83% 59.83% 59.83% 59.83% 59.83% 59.83% 59.83% 59.83% 59.83% 59.83% 59.83% Gross margin (loss) 40.39% 40.52% 40.61% 39.94% Selling, general & administrative expenses 30.68% 31.34% 31.60% 31.56% 31.17% 32.18% 31.42% 31.42% 31.42% 31.42% 31.42% 31.42% 31.42% 31.42% 31.42% 31.42% 31.42% 31.42% Operating income (loss) 7.05% 8.70% 8.79% 8.96% 10.83% 6.81% 8.52% 8.52% 8.52% 8.52% 8.52% 8.52% 8.52% 8.52% 8.52% 8.52% 8.52% 8.52% Interest on debt 2.05% 1.95% 1.68% 1.48% 1.96% 2.09% Interest on capitalized leases -0.04% -0.04% -0.04% -0.03% -0.02% -0.02% Interest expense, gross 2.13% 2.02% 1.74% 1.91% 1.89% 1.73% Interest expense 2.11% 2.01% 1.74% 1.91% 1.88% 1.67% 1.89% 1.89% 1.89% 1.89% 1.89% 1.89% 1.89% 1.89% 1.89% 1.89% 1.89% 1.89% Interest income 2.11% 2.01% 1.74% 1.91% 1.88% 1.67% Income (loss) fr cont opers bef income taxes 4.98% 6.79% 7.10% 7.14% 9.13% 5.36% Total income tax expense-federal 1.35% 2.18% 2.40% 2.43% 2.59% 1.51% Total income tax expense-state & local 0.32% 0.48% 0.16% 0.30% 0.40% 0.19% Federal, state & local income tax expense 1.67% 2.66% 2.56% 2.73% 3.00% 1.70% Income (loss) from continuing operations 3.31% 4.13% 4.54% 4.41% 6.13% 3.66% Discontinued operations, net of income taxes 0.15% 0.03% Net income (loss) -1.76% 5.30% 4.54% 4.41% 6.28% 3.69% 3.74% 3.740% 3.740% 3.740% 3.740% 3.740% 3.740% 3.740% 3.740% 3.740% 3.740% 3.740%

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The next line item to be forecasted was the cost of goods sold. We used

an average from the common sized income statement and came up with 59.83%

of net sales each year. The common sized income statement is very important as

it helps us see everything as a percentage of sales. We felt this was fair because

the growth of cost of goods sold has been increasing steadily at this rate over

the past five years. After that, we subtracted the forecasted sales from the cost

of goods sold to get the gross profit. We also used the common sized income

statement to forecast the SG&A expenses, operating profit, interest expense, and

net income. We did not forecast every line item on the income statement

because not every measurement is able to be forecasted, such as taxes.

Balance Sheet

We began by computing the ratios that are directly linked to the balance

sheet and eliminated the ones we believed to be irrelevant. We then used the

inventory turnover, accounts receivable turnover, asset turnover, and current

ratios.

The asset portion of the balance sheet was examined first. In order to

forecast cash and cash equivalents, total current assets, and net property and

equipment, we averaged years 2001-2006 in each category to come up with a

percentage rate. The next item inspected was the accounts receivable turnover

ratio. For this ratio, we computed a value of 5.86, which allowed us to forecast

the accounts receivable account. We then moved on to the inventory turnover

ratio so we could forecast the inventories account. We calculated our inventory

turnover ratio at 3.01, which is not far behind the industry average of 3.37. The

main estimation we focused on for the asset section was the asset turnover

ratio. This ratio is a prime indication of how well a firm is utilizing their assets

and links the balance sheet to the income statement through net income. We

determined our asset turnover to be 0.91; which by industry standards, is low

considering the industry average is around 1.32.

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Macys Inc

Actual financial statements forecast financial statements

2001 2002 2003 2004 2005 2006 ASSUME 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 As Reported Annual Balance Sheet 2/2/2002 2/1/2003 1/31/2004 2/1/2005 2/1/2006 2/3/2007 Millions Millions Millions Millions Millions Millions ASSETS Current assets:

Cash and cash equivalents 636 716 925 868 248 1,211 4.35% 1,427

1,580

1,749

1,937

2,144

2,374

2,628

2,910

3,221

3,566

3,948

Accounts receivable 2,379 2,945 3,216 3,418 2,522 517 5.86 5,095

5,641

6,245

6,914

7,655

8,474

9,382

10,387

11,499

12,731

14,094

Merchandise inventories 3,376 3,359 3,215 3,120 5,459 5,317 3.01 5,935

6,571

7,274

8,053

8,916

9,871

10,928

12,098

13,394

14,829

16,417

Supplies and prepaid expenses 124 124 99 104 203 251 Assets from discontinued operations 744 1,713 126 Deferred income tax assets 21 10 Total current assets 7,280 7,154 7,455 7,510 10,145 7,422 42.29% 13,876 15,362 17,007 18,829 20,845 23,078 25,550 28,286 31,315 34,669 38,382 Long-term assets:

Net property and equipment 6,506 6,379 6,174 6,018 12,034 11,473 40.66% 13,341

14,770

16,352

18,103

20,042

22,189

24,565

27,196

30,108

33,333

36,903

Goodwill 508 262 262 260 9,520 9,204 Other intangible assets, net 683 378 378 378 1,080 883 Other assets, net 575 268 284 719 389 568 Total Non-Current Assets 8,272 7,287 7,098 7,375 23,023 22,128 18,936 20,964 23,209 25,694 28,446 31,493 34,866 38,600 42,734 47,311 52,378 Total Assets 15,552 14,441 14,553 14,885 33,168 29,550 0.91 32,812 36,326 40,216 44,523 49,292 54,571 60,415 66,886 74,049 81,980 90,760 LIABILITIES AND SHAREHOLDERS EQUITY Current liabilities: Short-term debt 1,012 946 908 1,242 1,323 650 Accounts payable and accrued liabilities 2,645 2,584 2,613 2,707 5,246 4,944 Income taxes 57 71 362 352 454 665 Deferred income taxes 103 52 Liabilities of discontinued operations 464 48 Total current liabilities 3,714 3,601 3,883 4,301 7,590 6,359 1.17 11,860 13,130 14,536 16,093 17,817 19,725 21,837 24,176 26,765 29,632 32,806 Long-term liabilities: Long-term debt 3,859 3,408 3,151 2,637 8,860 7,847 Deferred income taxes 1,345 998 998 1,199 1,704 1,728 Other liabilities 1,070 672 581 581 1,495 1,362 Total Non-current Liabilities 6,274 5,078 4,730 4,417 12,059 10,937 Total liabilities 9,988 8,679 8,613 8,718 19,649 17,296 19,723 22,292 25,113 28,213 31,621 35,370 39,496 44,037 49,038 54,547 60,617 Stockholders Equity Dividends 0 0 68 92 164 274 3% 282 291 299 308 318 327 337 347 358 368 379 Common Stock 3 3 2 2 3 6 Additional paid-in capital 5,098 5,106 3,880 3,124 9,241 9,486 Retained earnings 2,367 3,185 3,809 4,405 5,654 6,375 7,209 8,155 9,224 10,431 11,791 13,321 15,041 16,970 19,133 21,554 24,264 Treasury Stock -1,881 -2,252 -1,477 -1,322 -1,091 -3,431 Accumulated other comprehensive income (loss) -12 -273 -270 -40 -288 -182 Unearned Restricted Stock -11 -7 -4 -2 Total shareholders' equity 5,564 5,762 5,940 6,167 13,519 12,254 13,088 14,034 15,103 16,310 17,670 19,200 20,920 22,849 25,012 27,433 30,143 Total Liabilities and Shareholders' Equity 15,552 14,441 14,553 14,885 33,168 29,550 32,812 36,326 40,216 44,523 49,292 54,571 60,415 66,886 74,049 81,980 90,760

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Macy's Common Sized Balance Sheet Actual financial statements Forecasted Financial Statements

2,007 2008 2009 2010 2011 2012 2013 2014 2015 2016 ASSETS Current assets: Cash and cash equivalents 4.09% 4.96% 6.36% 5.83% 0.75% 4.10% 4.35% 4.35% 4.35% 4.35% 4.35% 4.35% 4.35% 4.35% 4.35% 4.35% 4.35% 4Accounts receivable 15.30% 20.39% 22.10% 22.96% 7.60% 1.75% 15.53% 15.53% 15.53% 15.53% 15.53% 15.53% 15.53% 15.53% 15.53% 15.53% 15Merchandise inventories 21.71% 23.26% 22.09% 20.96% 16.46% 17.99% 18.09% 18.09% 18.09% 18.09% 18.09% 18.09% 18.09% 18.09% 18.09% 18.09% 18Supplies and prepaid expenses 0.80% 0.86% 0.68% 0.70% 0.61% 0.85% Assets from discontinued operations 4.78% 0.00% 0.00% 0.00% 5.16% 0.43% Deferred income tax assets 0.14% 0.07% 0.00% 0.00% 0.00% 0.00% Total current assets 46.81% 49.54% 51.23% 50.45% 30.59% 25.12% 42.29% 42.29% 42.29% 42.29% 42.29% 42.29% 42.29% 42.29% 42.29% 42.29% 42.29% 42Long-term assets: Net property and equipment 41.83% 44.17% 42.42% 40.43% 36.28% 38.83% 40.66% 40.66% 40.66% 40.66% 40.66% 40.66% 40.66% 40.66% 40.66% 40.66% 40.66% 40Goodwill 3.27% 1.81% 1.80% 1.75% 28.70% 31.15% Other intangible assets, net 4.39% 2.62% 2.60% 2.54% 3.26% 2.99% Other assets, net 3.70% 1.86% 1.95% 4.83% 1.17% 1.92% Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100 LIABILITIES AND SHAREHOLDERS EQUITY Current liabilities: Short-term debt 6.51% 6.55% 6.24% 8.34% 3.99% 2.20% Accounts payable and accrued liabilities 17.01% 17.89% 17.96% 18.19% 15.82% 16.73% Income taxes 0.37% 0.49% 2.49% 2.36% 1.37% 2.25% Deferred income taxes 0.31% 0.18% Liabilities of discontinued operations 1.40% 0.16% Total current liabilities 23.88% 24.94% 26.68% 28.89% 22.88% 21.52% 36.15% 36.15% 36.15% 36.15% 36.15% 36.15% 36.15% 36.15% 36.15% 36.15% 36Long-term liabilities: Long-term debt 24.81% 23.60% 21.65% 17.72% 26.71% 26.55% Deferred income taxes 8.65% 6.91% 6.86% 8.06% 5.14% 5.85% Other liabilities 6.88% 4.65% 3.99% 3.90% 4.51% 4.61% Total liabilities 64.22% 60.10% 59.18% 58.57% 59.24% 58.53% 0.66 0.67 Shareholders' equity: Dividends 0.00% 0.00% 0.47% 0.62% 0.49% 0.93% 3% 1% 1% 1% 1% 1% 1% 1% 1% 0% 0% Common Stock 0.02% 0.02% 0.01% 0.01% 0.01% 0.02% Additional paid-in capital 32.78% 35.36% 26.66% 20.99% 27.86% 32.10% Retained earnings 15.22% 22.06% 26.17% 29.59% 17.05% 21.57% 22% 22% 23% 23% 24% 24% 25% 25% 26% 26% Treasury Stock -12.09% -15.59% -10.15% -8.88% -3.29% -11.61% Accumulated other comprehensive income (loss) -0.08% -1.89% -1.86% -0.27% -0.87% -0.62% Unearned Restricted Stock -0.07% -0.05% -0.03% -0.01% 0.00% 0.00% Total shareholders' equity 35.78% 39.90% 40.82% 41.43% 40.76% 41.47% 40% 39% 38% 37% 36% 35% 35% 34% 34% 33% Total Liabilities and Shareholders' Equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 1

79

We believe that our asset turnover was negatively affected by Macy’s

acquisition of May’s Department Stores in 2005. It is noticeable that our

property, plant, and equipment, as well as total non-current assets, spiked

dramatically in 2005-2006. This may be a result of Macy’s acquisition of May’s

Department Stores.

After the asset section, we examined the liability and equity sections of

the balance sheet. The current ratio was used to forecast Macy’s total current

liabilities. To do this, we divided the current ratio, of 1.7, into the current assets

for 2006 to arrive at 2007’s current liability forecast. Finally, we focused on

dividends. It is especially important to note that before Macy’s acquisition of

May’s, dividend payments were almost non-existent. However, after the

acquisition, dividends showed a dramatic increase, so we grew the dividends out

using a 3% growth rate. The total shareholders’ equity is one of the most

important items to be forecasted on the balance sheet because it’s a check

figure. These numbers add up to equal the numbers on the valuation methods.

To forecast the shareholders’ equity, we added together last year’s shareholders’

equity and next year’s retained earnings, and then subtracted last year’s retained

earnings.

Statement of Cash Flows

The cash flow statement is one of the hardest financial statements to

forecast because it has several inconsistencies. The first thing we did was to

calculate the CFFO/NI, CFFO/OI, and CFFO/Sales ratios to see which ratio

showed the most consistencies. We found that the CFFO/Sales showed the

largest range of consistency among the three ratios that we ran. We used this

ratio to forecast out the cash from operating activities. “Cash flow from financing

activities reports the aggregate change in a company’s position resulting from

any gains or losses from investing in a financial market or resulting from

amounts spent in capital assets such as plant and equipment,” (Financial

dictionary). Therefore, the negative cash flows will reflect money spent on assets

80

or investment. To forecast the CFFI, we first used the CFFO/sales ratio for

forecasting, but the numbers were too large and inconsistent. We then went

back to the balance sheet and looked at the non-current assets. We noticed that

in 2005 and 2006, the property and equipment was almost half of the non-

current assets. This means that the CFFI’s for those 2 years were negative

because they show that Macy’s had heavy investing expenditures on plant and

property. As we forecasted out the non-current assets only 2008, the first year,

had a positive cash flow and the rest of years had negative cash flows. We did

not think this was consistent, especially taking into considering that Macy’s had

just acquired May’s. Since this forecast was illogical, we changed that cash flow

to be negative in order to avoid heavily understating Macy’s stock price in our

valuation. We did not forecast too many items on the cash flow statement since,

as seen from the two items we forecasted, they are based on a lot of

assumptions and have a great deal of inconsistencies.

81

Macy's Actual financial statements Forecast Financial Statements

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 As Reported Annual Cash Flow 2/2/2002 2/1/2003 1/31/2004 1/29/2005 1/28/2006 2/3/2007 Millions Millions Millions Millions Millions Millions Net income (loss) -276 818 693 689 1,406 995 Income (loss) from discontinued operations 784 -180 - - -33 -7 Depreciation & amortization 657 676 706 734 943 1,265 Accounts receivable 83 39 -257 - - - Merchandise inventories 305 17 143 95 495 -51 Supplies & prepaid expenses - - 25 -5 122 -41 Other assets not separately identified -52 -87 2 -1 -2 25 Accts pay & accrued liabil not sep identified -236 -1 60 -24 -444 -841 Current income taxes -181 14 284 -6 49 -139 Deferred income taxes 17 -119 3 59 -36 -18 Other liabilities not separately identified 7 -18 -76 -60 -132 12 Net cash flows from operating activities 1,372 1,168 1,590 1,507 1,950 3,692 $4,006 $4,346 $4,716 $5,117 $5,552 $6,023 $6,535 $7,091 $7,694 $8,348 $9,057 Purchase of property & equipment -615 -568 -508 -467 -568 -1,317 Capitalized software -36 -59 -60 -81 -88 -75 Disposition of property & equipment 55 20 6 27 19 679

Net cash flows from investing activities -771 -637 -562 -727 -2,506 1,273 $3,192 -

$2,028 -

$2,245 -

$2,486 -

$2,752 -

$3,047 -

$3,373 -

$3,734 -

$4,134 -

$4,577 -

$5,067 Debt issued 1,000 7 164 186 4,580 1,146 Financing costs -16 -1 - - -2 -10 Debt repaid -1,140 -1,015 -457 -365 -4,755 -2,680 Dividends paid - - -69 -93 -157 -274 282 291.00 299.00 308 318 327 337 347 358 368 379 Increase (decrease) in outstanding checks 37 -3 -5 38 -53 -77 Acquisition of treasury stock -299 -392 -645 -901 -7 -2,500 Issuance of common stock 323 29 193 298 336 382 Net cash flows from financing activites -95 -1,375 -819 -837 -58 -4,013 Net cash flows from continuing operations 506 -844 209 -57 -614 952 Net cash flows from discontinued operating ac -92 924 - - 63 54 Net cash flows from discontinued investing ac - - - - -61 -97 Net cash flows from discontinued financing ac - - - - -8 54 Net cash flows from discontinued operations - - - - -6 11 Net incr (decr) in cash & cash equivalents 414 80 209 -57 -620 963 Cash & cash equivalents beginning of period 222 636 716 925 868 248 Cash & cash equivalents end of period 636 716 925 868 248 1,211 Interest paid 351 335 269 300 457 600 Interest received 7 14 8 16 42 59 Income taxes paid (net of refunds received) 221 123 60 322 481 561 CFFO/NI -4.97 1.43 2.29 2.19 1.39 3.71 CFFO/SALES 0.09 0.08 0.10 0.07 0.07 0.14 0 CFFO/OI 1.02 0.87 1.14 0.62 1.06 2.01

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Macy's Common Sized Cash Flows Actual financial statements Forecast Financial Statements

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Net income (loss) -20.12% 70.03% 43.58% 45.72% 72.10% 26.95% Income (loss) from discontinued operations 57.14% -15.41% #VALUE! #VALUE! -1.69% -0.19% Depreciation & amortization 47.89% 57.88% 44.40% 48.71% 48.36% 34.26% Accounts receivable 6.05% 3.34% -16.16% #VALUE! #VALUE! #VALUE! Merchandise inventories 22.23% 1.46% 8.99% 6.30% 25.38% -1.38% Supplies & prepaid expenses 1.57% -0.33% 6.26% -1.11% Other assets not separately identified -3.79% -7.45% 0.13% -0.07% -0.10% 0.68% Accts pay & accrued liabil not sep identified -17.20% -0.09% 3.77% -1.59% -22.77% -22.78% Current income taxes -13.19% 1.20% 17.86% -0.40% 2.51% -3.76% Deferred income taxes 1.24% -10.19% 0.19% 3.92% -1.85% -0.49% Other liabilities not separately identified 0.51% -1.54% -4.78% -3.98% -6.77% 0.33% Net cash flows from operating activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Purchase of property & equipment 79.77% 89.17% 90.39% 64.24% 22.67% -

103.46% Capitalized software 4.67% 9.26% 10.68% 11.14% 3.51% -5.89% Disposition of property & equipment -7.13% -3.14% -1.07% -3.71% -0.76% 53.34% Net cash flows from investing activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Debt issued Financing costs Debt repaid Dividends paid Increase (decrease) in outstanding checks Acquisition of treasury stock Issuance of common stock Net cash flows from financing activites Net cash flows from continuing operations Net cash flows from discontinued operating ac Net cash flows from discontinued investing ac Net cash flows from discontinued financing ac Net cash flows from discontinued operations Net incr (decr) in cash & cash equivalents Cash & cash equivalents beginning of period Cash & cash equivalents end of period Interest paid Interest received Income taxes paid (net of refunds received)

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Cost of Capital Estimation

A firm grows by either issuing debt, equity, or using internal financing.

Therefore, to value a firm we have to see how much debt they actually have.

This is to ensure they are not giving a wrong impression of being successful

when they are actually in debt. In order to calculate the cost of capital, we need

to calculate the cost of equity and the cost of debt.

Cost of Equity

The cost of equity of a company is “the rate of return on investment that

is required by the company’s ordinary shareholders,” (Wikipedia). We used the

CAPM model to calculate our cost of equity. The formula consists of the firm’s

beta, market premium, and the risk-free rate.

We started by calculating the beta. To do that, we ran a number of

regression analyses to come up the best beta estimation. We used the St. Louis

Federal reserve website to get the constant maturity rates that we needed. We

ran regressions for six periods in order to test for the highest explanatory power

of R^2. These periods were: 3 months, 1 year, 2 years, 5 years, 7 years and 10

years. In each period we ran regressions for 72, 60, 48, 36, and 24 months, to

test the stability of beta over time. Macy’s beta results were pretty constant from

period to period with just a little variation, which means that Macy’s beta was

pretty constant over time. We picked the beta with the highest explanatory

power, which is the highest R^2. It is important to use the beta with the highest

R^2, and with the T-stat higher than 1.69, which happened to be the 72 month

regression on every observation. The 3 month regression was the best choice

because it had the highest overall R^2. This made our chosen beta 1.26, which

is different from Macy’s published beta of 1.03. After going through the

regression analysis, it is not so clear how fiancé.yahoo.com came up with that

beta, because none of our regression tables yielded anything close to it. Since

the 3 month regression yielded the best beta in all periods, it means that the T-

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bill interest rate in that period would give the best estimate of the risk-free rate.

This rate is equal to 4.01%.

After researching several websites and reading through the textbook, we

chose to use 8.5% for our MRP. We came to this conclusion because Macy’s is in

the high-end retail industry and there is little volatility from year to year unless

an event such as a merger or an acquisition, like Macy’s had in 2005, occurs.

After looking at Macy’s history of acquisitions and ventures sales we increased

the MRP by 1.7% to accommodate for Macy’s market cap, based on the table

from the textbook. Once all of these rates were calculated, finding the Ke for

Macy’s was a simple math equation. We applied all of the rates that pertain to

Macy’s into the CAPM formula to compute a cost of equity of 14.72%.

Ke=.0401+1.26(.085)

=14.72%

3 mo Beta T-Stat R^2 Ke

72 1.26 2.8 0.088 0.147260 1.63 2.24 0.064 0.178748 1.41 1.29 0.013 0.160036 1.65 1.16 0.01 0.180424 1.65 0.75 -0.019 0.1804

1 yr Beta T-Stat R^2 Ke

72 1.25 2.79 0.087 0.146460 1.52 2.11 0.084 0.169348 1.36 1.25 0.0197 0.155736 1.55 1.097 0.024 0.171924 1.3 0.57 -0.039 0.1506

2 yrs Beta T-Stat R^2 Ke

72 1.25 2.78 0.086 0.146460 1.62 2.23 0.063 0.177848 1.39 1.27 0.012 0.158336 1.63 1.15 0.009 0.178724 1.65 0.75 -0.019 0.1804

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5 yrs Beta T-Stat R^2 Ke

72 1.24 2.76 0.085 0.145560 1.61 2.21 0.061 0.177048 1.37 1.26 0.012 0.156636 1.63 1.15 0.001 0.178724 1.66 0.75 -0.019 0.1812

7 yrs Beta T-Stat R^2 Ke

72 1.24 2.75 0.084 0.145560 1.6 2.2 0.06 0.176148 1.36 1.25 0.011 0.155736 1.62 1.14 0.009 0.177824 1.66 0.75 -0.019 0.1812

10 yrs Beta T-Stat R^2 Ke

72 1.23 2.75 0.084 0.144760 1.59 2.19 0.06 0.175348 1.36 1.24 0.011 0.155736 1.62 1.14 0.008 0.177824 1.67 0.75 -0.019 0.1821

Cost of Debt

The cost of debt is the interest rate that Macy’s pays on all of its debt. For

our purposes, we are calculating the weighted-average cost of debt. Therefore,

we needed to discover the short-term interest rate and also the interest rate paid

on long-term debt. In the end, we concluded that the weighted-average cost of

debt for Macy’s is 6.22%. This percentage was calculated through a several step

process.

First, we analyzed the Macy’s 10-K report to collect all of the short-term

debt that the company had in 2006. Then, we found the weighted average of

those numbers and turned all of them into one percentage that represents all

outstanding short-term debt, which equals 5.42%. Repeating this process for all

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outstanding long-term debt equals 6.68%. These are the two percentages we

needed to calculate the weighted-average cost of debt. Next, we applied the

short-term percentage to the current liabilities portion and applied the long-term

percentage to the non-current liabilities portion of the Balance Sheet. The weight

of each account is calculated by dividing the account balance by the total

liabilities of the firm. Once we knew the weights, we multiplied them with their

corresponding interest rates to create the values of the weights. Finally, all of the

weight values are added together to yield the weighted-average cost of debt.

LIABILITIES AND SHAREHOLDERS EQUITY

Interest rate Weight

Value weighted rate

Current liabilities: Short-term debt $650,000 5.42% 0.0376 0.20% Accounts payable and accrued liabilities $4,944,000 5.42% 0.2858 1.55% Income taxes $665,000 5.42% 0.0384 0.21% Deferred income taxes $52,000 5.42% 0.0030 0.02% Liabilities of discontinued operations $48,000 5.42% 0.0028 0.02% Total current liabilities $6,359,000 5.42% 0.3677 1.99% Long-term liabilities: Long-term debt $7,847,000 6.68% 0.4537 3.03% Deferred income taxes $1,728,000 6.68% 0.0999 0.67% Other liabilities $1,362,000 6.68% 0.0787 0.53% Total liabilities $17,296,000 6.2168% Shareholders' equity: Common Stock $6,000 Additional paid-in capital $9,486,000 Retained earnings $6,375,000 Treasury Stock ($3,431,000) Accumulated other comprehensive income (loss) ($182,000) Total shareholders' equity $12,254,000 Total Liabilities and Shareholders' Equity $29,550,000

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Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is a calculation of Macy’s

debt and equity combined proportionally to yield a “weighted” percentage of the

company’s capital. For our research, we looked at the WACC on a before and

after tax basis. Calculating the WACC was one of the easier parts of our research

because all of the components were already found, we just simply had to insert

them into the formula.

As stated earlier, we calculated the WACC for Macy’s both before and

after taxes. The before tax WACC for our company is 10.25%. The steps taken

to discover this percentage went straight through the formula. We calculated the

cost of debt (as reported earlier) and multiplied it by its weight, 0.11. Then, we

found the cost of equity and multiplied it with its weight, 0.89. After that, we

added the two together to produce our WACC before taxes. The WACC after tax

rate was the same process with one addition, taxes. We calculated the effective

tax rate for Macy’s to be 35% by dividing the 2006 tax expense by the income

before taxes. Then, we followed the formula again, this time applying

(1 – tax rate) to the cost of debt. Adding together the weighted cost of debt

after tax and the weighted cost of equity, we concluded that the WACC after tax

for Macy’s is 9.11%.

WACC(BT)

Vd/Vf (Kd) + Ve/Vf (Ke)

17,296/32,968 (.062) +15,672/32,968 (.1472)

=10.25%

WACC(AT)

Vd/Vf (Kd) (1-Tax) + Ve/Vf (Ke)

17,296/32,968 (.062) (1-.35) + 15,672/32,968 (.1472)

=9.11%

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Credit Risk Analysis

The Altman Z- Score is a formula used to determine the credit risk of a

company. If the company’s Z- Score is greater than 2.67, then it falls into the

category of low credit risk. However, if the firm’s Z-Score is less than 1.81, then

it is considered a high credit risk. Furthermore, if the credit score falls anywhere

in between the range of 1.81 to 2.67, then it is labeled as the gray area.

Therefore, it is undetermined whether the company has a high or low credit risk.

The Altman Z- Score is calculated by using the following formula.

Z- Score =

1.2(Working Capital / Total Assets) + 1.4(Retained Earnings / Total Assets) +

3.3(EBIT / Total Assets) + .6(MVE / BVL) + 1.0 (Sales / Total Assets)

We calculated the Altman Z- Score for Macy’s for the last five years and

came up with these results.

2002 2003 2004 2005 2006 2.65 3.14 3.18 2.8 2.211

As one can see, the credit risk for Macy’s Inc. has been relatively

low throughout the past five years. However, over the last few years the credit

score has dropped gradually and in 2006, their credit score fell into the grey

area. This may cause concern to the company and investors if their credit score

continues to decline.

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Method of Comparables

Macy's Share Price Forward P/E $60.69Trailing P/E $23.01Price to Book $75.96Dividend Yield $55.17P.E.G $74.82Price to EBITDA $61.12EV to EBITDA $2.46Price to Free Cash Flows NA

The method of comparables is used to find the share price of a firm base

upon an industry average. We calculated the ratios for Macy’s, as well as the

ratios for Sacs, Dillard’s, and Nordstrom’s, and then calculated an average for our

industry. By using the industry average for our ratio we were able to work back

to find a Price per Share. Then By comparing the calculated share price to the

posted share price as of November 1, 2007, we are able to make an assumption

on whether the firm is overvalued, undervalued, or fairly priced.

Forward P/E Ratio

Forward P/E PPS EPS P/E

Industry Average

Macy's Share Price

Macy's 31.54 2.36 13.36 25.72 60.69 Sacs 21.89 0.69 31.72 Dillard's 21.73 0.64 33.95 Nordstrom 37.75 3.29 11.47

We calculated the forward P/E ratio by dividing the stock price as of

November 1, 2007 by the forecasted earnings per share for Macy’s. For all of

the ratios for our competitors, we used the numbers posted on yahoo finance,

but again using the share price as of November 1. To find Macy’s Share Price we

took the average of our competitors P/E ratios and multiplied that number by

Macy’s earning s per share. This gave us a share price of $60.69, which

compared to the posted $31.54; suggest that our firm is undervalued. However

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we must take into consideration that Sacs and Dillard’s both had extremely low

earnings per share, causing their P/E ratios to be high and creating a high

industry average.

Trailing P/E ratio

Trailing P/E PPS EPS P/E

Industry Average

Macy's Share Price

Macy's 31.54 2.22 14.21 10.37 23.01 Saks 21.89 0.21 104.24 Dillard's 21.73 3.36 7.99 Nordstrom 37.75 2.71 12.74

The trailing P/E ratio is calculated by dividing the stock price by the

earnings per share for the past twelve months. This ratio differs from the

forward P/E because it uses actual earnings; also making it a more accurate

valuation. We then took the average P/E of our competitors (excluding Saks)

and multiplied that number by our earnings per share, giving us a share price of

$23.01. Compared to the posted $31.54, this valuation shows that the firm is

currently overvalued. Again, because this ratio is based on previous earnings per

share, we should regard this more viable than the forward P/E ratio.

Price to Book Ratio

Price to Book PPS BPS P/B

Industry Average

Macy's Share Price

Macy's 31.54 24.66 1.28 3.08 75.96 Saks 21.89 8.42 2.60 Dillard's 21.73 34.49 0.63 Nordstrom 37.75 6.28 6.01

The price to book ratio compares the price per share to the book value of

equity. It is calculated by dividing the current PPS (31.54) by the BPS (24.66) to

get our P/B ratio of 1.28. This is good, because a P/B ratio greater than 1

usually means a company is creating value. By again finding the industry

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average of our competitors and multiplying by our BPS we get a share price of

$75.96. This valuation, compared to a posted price of $31.54, suggests that

Macy’s is significantly undervalued. With this assumption we must consider that

the BPS for both Macy’s and Dillard’s is three to four times the size of Saks and

Nordstrom’s.

Dividend Yield

Dividend Yield PPS DPS D/P

Industry Average

Macy's Share Price

Macy's 31.54 0.51 0.016 0.009 55.17 Saks 21.89 NA NA Dillard's 21.73 0.16 0.007 Nordstrom 37.75 0.42 0.011

Macy’s dividend yield (D/P) is calculated by dividing the dividends per

share by the current price per share. We then calculated the D/P for our

competitors using their posted DPS, and then took an average of these numbers.

We could not calculate Saks dividend yield because they did not pay out a

dividend. To then find Macy’s share price of $55.17 we divided our DPS of 0.51

by the industry average of 0.009. This ratio also suggests that Macy’s is

currently undervalued. However, because Sacs didn’t pay dividends, our sample

for the industry average is relatively small and may be unreliable.

Price/Earnings to Growth Ratio

P.E.G Ratio PPS EPS PEG

Industry Average

Macy's Share Price

Macy's 31.54 2.22 1.33 3.15 74.82 Saks 21.89 0.69 3.93 Dillard's 21.73 1.04 4.46 Nordstrom 37.75 3.40 1.05

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The Price-Earnings Growth ratio is used to establish a stock’s P/E relative

to the earnings growth rate. By taking the trailing P/E ratio and dividing it by the

earnings per share growth rate, we get a firms P.E.G ratio. For our valuation we

took the average of our competitors PEG ratios and multiplied it by our growth

rate and our EPS to get a share price of $74.82. This valuation also implies that

Macy’s is significantly undervalued.

Price to EBITDA Price to EBITDA PPS EBITDA P/EBITDA

Industry Average

Macy's Share Price

Macy's 31.54 1.84 17.14 33.22 61.12 Saks 21.89 0.22 98.60 Dillard's 21.73 0.53 41.27 Nordstrom 37.75 1.50 25.17

For this ratio we used the price per share as of November 1, 2007 and

EBITDA calculated from Macy’s 10-k. By dividing the PPS by the EBITDA we got

our Price to EBITDA of 17.14. We then used the given numbers on yahoo

finance to calculate our competitors P/EBITDA ratio and then took the average

(excluding Saks). We calculated a share price of $61.12 for Macy’s by

multiplying the industry average by our EBITDA of 1.9. Comparing the posted

share price of $31.54 to the calculated $61.63 again tells us that Macy’s is

currently undervalued.

Enterprise value to EBITDA

Enterprise value to EBITDA EV EBITDA EV/EBITDA

Industry Average

Macy's Share Price

Macy's 29.74 1.84 16.16 9.32 2.46 Saks 3.47 0.22 15.63 Dillard's 3.02 0.53 5.74 Nordstrom 9.89 1.50 6.59

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The enterprise value (EV) to EBITDA is calculated by dividing the firms EV

by its EBITDA. To find Macy’s EV we took its price per share times outstanding

shares plus the book value of liabilities minus cash. We then divided that

number by Macy’s EBITDA to get 16.16. Next we calculated the EV/EBITDA for

each of the competitors and took the average. Then by inserting the industry

average as the EV/EBITDA and solving for price (using the same number of

liabilities, cash, and shares), we came up with a share price of $2.46 for Macy’s.

This number compared to our November 1 stock price of $31.54 would suggest

that the company is extremely overpriced. However, due to the extremely large

enterprise value of Macy’s, this number does not represent good assessment of

the value of the company.

Price to Free cash flows Price to Free cash

flows PPS FCF P/FCF Industry Average

Macy's Share Price

Macy's 31.54 5.14 6.14 NA NA Saks 21.89 1.24 17.63 Dillard's 21.73 0.09 230.61 Nordstrom 37.75 0.90 42.13

The price to free cash flows ratio is calculated by dividing the current

stock price of the firm by the free cash flows. Then we would have found an

industry average and then calculated Macy’s share price using this number. As

shown in the table above we had some huge discrepancies when we calculated

our P/FCF. This is due to large difference in the number of the free cash flows

from one firm to the next. Because of this we decided not to calculate the

industry average and share price, feeling that the number would not have been

an accurate assumption.

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Conclusion

The method of comparables is a tool for taking a quick look at a company

and its competitors and making an assumption based upon ratios. Five out of the

seven ratios we computed suggested that Macy’s is significantly undervalued.

However, we must question the accuracy and validity of these ratios. What they

fail to consider is the size and structure of the companies being compared.

Macy’s is significantly larger than the three competitors we compared it. With

higher earnings, costs, and liabilities, along with different capital structures, the

assumptions made by these ratios are just not accurate. The method of

comparables is good for a quick snapshot, but it just isn’t as viable as an intrinsic

valuation.

Intrinsic Valuation Methods

Intrinsic valuation models are models that we will use to help us estimate

or predict the value of Macy’s share price. This method uses the forecasted data

from the balance sheet, income statement, and the cash flow statements. We

also used WACC or Ke already calculated. We will be estimating Macy’s share

price using five different models: the discount dividend model, free cash flows

model, residual income model, residual income perpetuity, and the abnormal

earnings model.

In every model we calculate a perpetuity, and then discount that

perpetuity back to the current year. Then, we discount that number back to the

valuation date of the project, which we are valuing Macy’s share price as of

November 1, 2007.

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Discounted Dividend Model

The discounted dividend model is the first valuation method that we

evaluated. This model has a lot of assumptions built into it, thus making it less

reliable as a method of stock valuation. One assumption that we made is that the

company will pay dividends indefinitely and that the dividends will grow at a

constant rate over the number of years.

To do this, we first identified the dividend per share and grew it out at a

rate of 3% over the next 10 years. The next step is to calculate the present

value by using the formula: 1/(1+Ke)^t. We then calculated the present value

of the dividends for each year by multiplying the dividends per share and the

present value factor together. The perpetuity started in 2018. We assumed that

the dividends would grow at the same 3% growth rate, so we took the

perpetuity and divided by (Ke minus the growth rate). Then, we discounted it

back to 2007 to get the terminal value of the perpetuity. Next, we added the

terminal value of the perpetuity to the sum of the present values of the dividends

to come up with a share price of $4.99. This share price is far below the

observed share price of $31.54, which means that using this model, we conclude

that Macy’s is extremely overvalued.

We conducted a sensitivity analysis to assess how sensitive the share

price was to changes in the Ke and growth.

Growth 0 0.03 0.107 0.11 0.13

0.1956 4.78 4.99 6.14 6.23 7.01

0.1574 4.93 5.29 7.83 8.1 11.41

0.1472 4.99 5.37 8.85 9.28 15.95

Ke 0.1114 5.33 6.02 50.82 152.29 N/A

0.1054 5.42 6.02 N/A N/A N/A

over valued under valued

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Macy’s sensitivity analysis clearly shows that they are an overvalued firm.

We did not place too much credibility on this model, since dividends are very

sticky. Therefore, there is no telling if Macy’s will continue paying dividends or if

the dividends will continue to grow at a constant rate.

Discounted Free Cash Flow

The discounted free cash flow valuation model is used to determine the

future value of cash flows for the next ten years and discount them back to the

present. This valuation model is based on the discount dividend model. For

instance, this particular model assumes that the only cash flows received by

stockholders are dividends. The dividends are equal to the operating cash flow,

minus the capital outlays, and plus the net cash flows from debt owners. We also

had to make some assumptions of our own. We assumed the 2008 CFFI was a

negative cash flow because the original calculated number was a positive cash

flow. This led to over-estimating the share price. We used the reasoning that

from 2006 to 2007 plant and property increased, but the non-current assets

decreased. This was inconsistent with logic because if plant and property

increased, then logically the non-current assets would also increase. Based on

that, we assessed a negative cash flow in 2008.

In order to calculate the annual free cash flows for the company, we

subtract the cash flows from investing out of the cash flows from operating

activities. This present value of free cash flows is equal to the market value of

liabilities plus the market value of equity. After that, it is necessary to determine

the present value factor. This is computed by using the formula:

(1/(1+WACC)^t. The present value factor is then multiplied by the annual free

cash flow to get the present value of free cash flows. Next, we calculated the

total present value of future cash flows by computing the sum of the present

value of cash flows over the forecasted ten year period.

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Furthermore, the terminal value of the perpetuity is calculated by taking

the value of the perpetuity and dividing it by the (WACC minus the growth rate).

This number is then multiplied by the present value factor to get the terminal

value of the perpetuity. Next, the total present value of the free cash flows is

added to the present value of the terminal value of the perpetuity. Then, the

book value of liabilities is subtracted out to get the estimated market value of

equity. The market value of equity is divided by the number of outstanding

shares to discover the estimated price per share. Lastly, we calculate the time

consistent implied by discounting back to November 1 using the following

formula: est. price per share x (1+ WACC before tax) ^ (10/12).

Sensitivity Analysis:

Growth

0 0.03 0.05 0.07 0.09

0.08 83.62 117.52 168.97 426.2 N/A

0.09 78.06 97.74 127.27 215.84 N/A

WACC 0.1025 67.86 80.74 97.49 134.86 291.83

0.1125 61.39 70.87 82.25 104.33 165.68

0.1325 51.49 56.98 62.87 72.52 91.24

over valued undervalued

The sensitivity analysis exposes that there is a great deal of price

variation. For instance, by changing the growth rate to 7% at an 8% WACC, the

estimated share price increases by nearly five times the original price. In

addition, a higher discount rate causes the estimated share price to decrease.

Our sensitivity analysis reveals that our share price is overvalued at every growth

rate.

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Residual Income Valuation

“Residual income, also known as passive income, is income earned on an

ongoing basis for effort done once in the past,” (Wikipedia). Based on this

definition, we believe this valuation model attempts to show how much Macy’s is

worth, plus any value added. Of all the valuation models, the residual income

model has the highest degree of explanatory power, and is therefore the most

reliable. We used the net income and dividends from our forecasts in our

calculations.

To calculate the equity, we took the previous year’s equity, added the

current year’s net income, and subtracted the current year’s dividends. The

equity calculated should match the equity on the forecasted balance discussed

earlier. We then calculated the benchmark earnings by multiplying the previous

year’s equity by the cost of equity (Ke) of 14.72%. We computed the difference

of the benchmark earning and the net income to see if Macy’s is creating or

destroying value. Our result revealed that Macy’s is destroying value every year,

so our recommendation is to stop operations. Next, we discounted the perpetuity

back using a growth rate of -0.1%. We used a negative growth rate in the

residual income model because we are trying to bring the negative residual

income back to equilibrium. A positive growth rate would continue increasing the

value instead of bringing it to zero.

Finally, we added the equity, the annual residual income, and the terminal

perpetuity. We divided this sum by the number of shares outstanding, which is

496 million, to compute a share price of $17.65 (as of November 1, 2007). Once

again, this shows that Macy’s is overvalued being traded at the observed price of

$31.54.

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Growth 0 -0.1 -0.2 -0.3 -0.4

0.0522 55.77 45.18 42.99 42.05 41.52

0.1156 23.28 23.65 23.78 23.85 23.9

Ke 0.1472 17.65 18.23 18.47 18.61 18.69

0.1988 12.12 12.53 12.74 12.86 12.94

0.2033 11.77 12.16 12.36 12.48 12.56

over valued under valued

The sensitivity analysis above shows that Macy’s is overvalued. However,

the results confirm that the share price is sensitive to changes in Ke and growth

rate. If we reduce the Ke to 5.2%, the share price jumps above the observed

share price of $31.54. Macy’s being overvalued means that they would have to

drive sales in order to get the fair value. We estimated that sales would be

growing by 10.71%. These results conclude that Macy’s would have to nearly

triple their sales growth in order to obtain fair value. Everything in the sensitivity

analysis illustrates that Macy’s is overvalued except the top line of the table,

which diagrams a Ke of about 5%. However, a cost of equity that low is not

realistic because it’s unfathomable that Ke would fall that low.

Residual Income Perpetuity

This model is derived from the residual income model. It values Macy’s on

the basis of return on equity, the calculated Ke, and the growth rate. We used

the formula: Po= BVE(1+(ROE - Ke)/(Ke - G)

To calculate the ROE, we divided equity by net income and computed an

average. We then derived the growth rate from the ROE. With that, we were

able to calculate a share price of $15.07. This illustrates that Macy’s is

overvalued based on the observed share price of $31.54.

We then did three sensitivity analyses to see how sensitive the price was

to increase in ROE, Ke, and growth.

100

Growth 0.02 0.04 0.06 0.08 0.1

0.0972 24.02 23.15 21.36 15.4 94.59

0.1372 16.25 14 10.57 4.76 N/A

Ke 0.1472 15.07 12.77 9.42 4.08 N/A

0.1772 12.43 10.18 7.15 2.87 N/A

0.1972 11.17 8.99 6.18 2.41 N/A

ke 0.0973 0.1372 0.1472 0.1772 0.1972 0.05 10.28 6.96 6.46 5.33 4.76 0.07 17.13 11.61 10.76 8.88 7.98ROE 0.09 23.99 16.25 15.07 12.43 11.17 0.113 31.87 21.59 20.02 16.52 14.84 0.151 44.89 30.41 28.2 23.27 20.9

Growth 0.02 0.04 0.06 0.08 0.1 0.05 6.46 2.55 N/A N/A N/A 0.07 10.76 7.66 3.14 N/A N/A ROE 0.09 15.07 12.77 9.42 4.08 N/A 0.113 20.02 18.65 16.65 13.45 7.54 0.151 28.2 28.36 28.58 28.93 29.59 overvalued undervalued within 5% fairly valued

The above sensitivity analyses clearly demonstrate that Macy’s is

overvalued.

101

Abnormal Earnings Growth

“The abnormal earnings growth rate says equity value consists of:

Capitalized next period earnings and the infinite sum of present values of

capitalized expected changes of earnings adjusted for dividends (abnormal

earnings),” (Yong Keun Yoo). This model is less reliable than the residual income

model. This model shows how drip income (dividends) affects earnings. The drip

income is calculated by multiplying last year’s dividends by the Ke. We then

calculated the normal annual income (benchmark) by dividing the previous year’s

net income by (1+Ke). AEG was computed at by getting the difference of the

cumulative dividends income and the benchmark. The change in residual income

should equal the AEG as shown below. This is what links the AEG model and the

residual income model.

Change in Residual Income -3.91 -6.10 -11.50 -14.67 -21.19 -26.22 -33.04 -39.95 -48.25Annual AEG -3.91 -6.10 -11.50 -14.67 -21.19 -26.22 -33.04 -39.95 -48.25

The perpetuity is discounted back to year ten by dividing it by (Ke minus

the growth rate). The AEG growth rate is negative, like the residual income

model, in order to bring the perpetuity back to zero. The present value of the

AEG is calculated using the present value factor. The share price was calculated

to be $15.01, which again, shows that Macy’s observed share price of $31.54 is

overvalued.

The sensitivity analysis clearly shows that Macy’s is overvalued with every

variation in growth rate and Ke.

102

Growth -0.01 -0.05 -0.09 -0.1 -0.11

0.1972 11.69 11.75 11.79 11.8 11.81

0.1672 13.45 13.54 13.61 13.62 13.63

Ke 0.1472 15.01 15.14 15.23 15.24 15.26

0.1272 17.04 17.23 17.34 17.04 17.39

0.1072 19.78 20.07 20.24 20.28 20.31

over valued under valued

Conclusion

From the intrinsic valuation models we can say that Macy’s is an

overvalued company. All of the valuation models, with the exception of the free

cash flow model, show the share price is less than the observed share price of

$31.54. We did not put too much credibility on the free cash flow model because

it is based on a lot of assumptions, and has a low level of explanatory power.

103

Appendix

Liquidity Ratios

Current Ratio Quick Asset Ratio

2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 1.99 1.92 1.75 1.34 1.17 Macy's 1.05 1.09 1.02 0.62 0.33 Saks 2.41 2.11 2.21 1.95 1.45 Saks 0.77 0.61 0.6 0.99 0.54 Dillard's 3.53 2.26 2.19 1.87 2.1 Dillard's 1.73 1.04 0.54 0.3 0.28 Nordstrom 2.38 2.33 1.92 1.77 1.91 Nordstrom 1.23 1.28 1.23 1.18 1.2 Industry Average 2.58 2.16 2.02 1.73 1.66 Industry Average 1.20 1.01 0.85 0.77 0.59

Inventory Turnover Days Supply Inventory

2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 2.76 2.83 2.98 2.43 3.01 Macy's 132.25 128.98 122.48 150.21 121.26 Saks 2.86 2.59 2.64 4.64 2.3 Saks 127.62 140.93 138.26 78.66 158.7 Dillard's 3.30 3.17 2.90 2.78 2.84 Dillard's 110.76 115.24 126.06 131.23 128.54 Nordstrom 4.26 4.43 4.95 5.11 5.32 Nordstrom 87.21 82.56 73.52 71.42 71.54 Industry Average 3.29 3.25 3.37 3.74 3.37 Industry Average 114.46 116.93 115.08 107.88 120.01

Receivables Turnover Days Sales Outstanding

2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 5.24 4.75 4.57 8.88 52.17 Macy's 69.66 76.84 79.87 41.1 7 Saks none none none none none Saks none none none none none Dillard's 5.91 6.38 780.08 603.70 726.69 Dillard's 61.74 57.23 0.47 0.61 0.50 Nordstrom 7.86 10.24 11.04 12.07 12.5 Nordstrom 45.58 36.25 33.04 28.52 28.32 Industry Average 6.34 7.12 265.23 208.22 263.79 Industry Average 58.99 56.77 37.79 23.41 11.94

Working Capital Turnover

2002 2003 2004 2005 2006 Macy's 25.37 8.76 4.87 4.28 4.34 Saks 5.26 5.62 5.65 7.45 7.58 Dillard's 3.53 4.50 6.03 7.54 7.13 Nordstrom 5.09 5.38 5.77 6.2 6.4 Industry Average 9.81 6.07 5.58 6.37 6.36

104

Profitability Ratios

Gross Profit Margin Operating Profit Margin 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 0.4 0.4 0.41 0.41 0.4 Macy's 0.087 0.088 0.090 0.110 0.068

Saks 0.37 0.38 0.38 0.37 0.39 Saks 0.039 0.038 0.03 0.034 -

0.007 Dillard’s 0.34 0.32 0.33 0.34 0.34 Dillard’s 0.02 0.001 0.023 0.017 0.033 Nordstrom 0.34 0.35 0.36 0.37 0.37 Nordstrom 0.02 0.05 0.08 0.09 0.11 Industry Average 0.36 0.36 0.37 0.37 0.38 Industry Average 0.042 0.044 0.056 0.063 0.051

Net Profit Margin Asset Turnover 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 0.05 0.05 0.04 0.06 0.04 Macy's 1.07 1.05 1.05 0.68 0.91 Saks 0.004 0.01 0.01 0.004 0.02 Saks 1.29 1.3 1.37 1.55 1.16 Dillard’s -0.05 0.001 0.016 0.016 0.032 Dillard’s 1.19 1.19 1.32 1.37 1.41 Nordstrom 0.02 0.04 0.05 0.07 0.04 Nordstrom 1.46 1.45 1.54 1.57 1.78 Industry Average 0.01 0.03 0.03 0.04 0.03 Industry Average 1.25 1.25 1.32 1.29 1.32

Return on Assets Return on Equity 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 0.05 0.05 0.05 0.09 0.03 Macy's 0.15 0.12 0.12 0.23 0.07 Saks 0.005 0.018 0.013 0.005 0.014 Saks 0.011 0.037 0.026 0.011 0.027 Dillard’s -0.06 0.001 0.02 0.02 0.05 Dillard’s -0.18 0.004 0.05 0.05 0.10 Nordstrom 0.02 0.05 0.08 0.11 0.14 Nordstrom 0.09 0.19 0.24 0.25 0.08 Industry Average 0.00 0.03 0.04 0.06 0.06 Industry Average 0.02 0.09 0.11 0.14 0.07

105

Capital Structure Ratios

Debt to Equity Times Interest Earned 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 1.51 1.45 1.41 1.45 1.41 Macy's 4.37 5.08 4.73 5.84 4.21 Saks 1.02 1 1.26 0.93 1.32 Saks 1.89 2 1.74 2.1 0.16 Dillard’s 1.95 1.87 1.45 1.36 1.09 Dillard’s 0.97 0.04 1.26 1.19 2.90 Nordstrom 2.05 2.01 1.57 1.35 1.41 Nordstrom 1.96 3.68 7.12 3.25 2.19 Industry Average 1.67 1.63 1.43 1.21 1.27 Industry Average 1.61 1.91 3.37 2.18 1.75

Debt Service Margin IGR 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Macy's 1.23 1.75 1.21 1.47 5.68 Macy's 6% 4.50% 4.33% 3.55% 2.17% Saks 57.79 3.07 46.51 24.1 0.23 Saks 0.50% 2.00% -3.25% 0.50% -1.89%

Dillard’s 3.55 3.07 3.30 3.82 1.76 Dillard’s -5.80% -0.10% 1.60% 1.90% 4.20% Nordstrom 22.5 1.94 5.53 2.66 3.5 Nordstrom 4.61% 13.24% 17.21% 21.36% 23.56% Industry Average 27.95 2.69 18.45 10.19 1.83 Industry Average -0.23% 5.05% 5.19% 7.92% 8.62%

SGR

2002 2003 2004 2005 2006

Macy's 15.06% 11.03% 10.44% 8.70% 5.23% Saks 1.01% 4.00% -7.35% 0.97% -4.39% Dillard’s -15.40% -0.20% 4.70% 4.70% 10.00% Nordstrom 5.70% 14.45% 19.12% 23.42% 24.50% Industry Average -2.90% 6.08% 5.49% 9.70% 10.04%

106

Methods of Comparables Forward P/E PPS EPS P/E

Industry Average Macy's Share Price

Macy's 31.54 2.36 13.36 25.72 60.69

Sacs 21.89 0.69 31.72

Dillard's 21.73 0.64 33.95

Nordstrom 37.75 3.29 11.47

Trailing P/E PPS EPS P/E Industry Average Macy's Share Price

Macy's 31.54 2.22 14.21 10.37 23.01

Saks 21.89 0.21 104.24

Dillard's 21.73 3.36 7.99

Nordstrom 37.75 2.71 12.74

Price to Book PPS BPS P/B Industry Average Macy's Share Price

Macy's 31.54 24.66 1.28 3.08 75.96

Saks 21.89 8.42 2.60

Dillard's 21.73 34.49 0.63

Nordstrom 37.75 6.28 6.01

P.E.G Ratio PPS EPS PEG Industry Average Macy's Share Price

Macy's 31.54 2.22 1.33 3.15 74.82

Saks 21.89 0.69 3.93

Dillard's 21.73 1.04 4.46

Nordstrom 37.75 3.40 1.05

Price to EBITDA PPS EBITDA P/EBITDA Industry Average Macy's Share Price

Macy's 31.54 1.84 17.14 33.22 61.12

Saks 21.89 0.22 98.60

Dillard's 21.73 0.53 41.27

Nordstrom 37.75 1.50 25.17

Price to Free cash flows PPS FCF P/FCF Industry Average Macy's Share Price

Macy's 31.54 5.14 6.14 NA NA

Saks 21.89 1.24 17.63

Dillard's 21.73 0.09 230.61

Nordstrom 37.75 0.90 42.13

Enterprise value to EBITDA EV EBITDA EV/EBITDA Industry Average Macy's Share Price

Macy's 29.74 1.84 16.16 9.32 2.46

Saks 3.47 0.22 15.63

Dillard's 3.02 0.53 5.74

Nordstrom 9.89 1.50 6.59

Dividend Yield PPS DPS D/P Industry Average Macy's Share Price

Macy's 31.54 0.51 0.016 0.009 55.17

Saks 21.89 NA NA

Dillard's 21.73 0.16 0.007

Nordstrom 37.75 0.42 0.011

107

3 MONTH REGRESSION

108

ONE YEAR REGRESSION

109

2 YEAR REGRESSION

110

5 YEAR REGRESSION

111

7 YEAR REGRESSION

112

10 YEAR REGRESSION

113

Cost of Equity, Weighted Average Cost of Debt, and WACC

LIABILITIES Interest rate Weight

Value weighted

rate Current liabilities: Short-term debt $650,000 5.42% 0.0376 0.20%Accounts payable and accrued liabilities $4,944,000 5.42% 0.2858 1.55%Income taxes $665,000 5.42% 0.0384 0.21%Deferred income taxes $52,000 5.42% 0.0030 0.02%Liabilities of discontinued operations $48,000 5.42% 0.0028 0.02%Total current liabilities $6,359,000 5.42% 0.3677 1.99%Long-term liabilities: Long-term debt $7,847,000 6.68% 0.4537 3.03%Deferred income taxes $1,728,000 6.68% 0.0999 0.67%Other liabilities $1,362,000 6.68% 0.0787 0.53%Total liabilities $17,296,000 Weighted Average Kd = 6.2168%

WACCBT = 10.2591%

Ke = 14.72% WACC= 9.1176% tax rate= 35%

114

Discounted Dividend Model

DISCOUNTED DIVIDENDS VALUATION WACC(BT) 0.1025 Kd 0.0622 Ke 0.1472 Perp 0 1 2 3 4 5 6 7 8 9 10 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 DPS (Dividends Per Share) 0.57 0.59 0.60 0.62 0.64 0.66 0.68 0.70 0.72 0.74 0.76 PV Factor 0.872 0.760 0.662 0.577 0.503 0.439 0.382 0.333 0.291 0.253 PV Dividends Year by Year 0.496 0.446 0.399 0.359 0.323 0.289 0.260 0.233 0.210 0.188 Total PV of Annual Dividends 3.202 Continuing (Terminal) Value Perpetuity 5.163 PV of Terminal Value Perpetuity 1.308 Growth time consistent price 0 0.03 0.107 0.11 0.13 Estimated Price per Share (February 1, 2007) 4.509 0.1956 4.78 4.99 6.14 6.23 7.01

Implied November 1, 2008 Price 4.999 0.1574 4.93 5.29 7.83 8.1 11.41

Observed Share Price 31.54 0.1472 4.99 5.37 8.85 9.28 15.95

Initial Cost of Equity (You Derive) 0.1472 Ke 0.1114 5.33 6.02 50.82 152.29 N/A

Perpetuity Growth Rate (g) 0 0.1054 5.42 6.02 N/A N/A N/A

. over valued under valued

115

Free Cash Flow Model

Free Cash Flow Valuation WACC (BT) 0.1025 Kd 0.0622 Ke 0.1472

Perp 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 0 1 2 3 4 5 6 7 8 9 10 EPS (Earnings Per Share) DPS (Dividends Per Share) BPS (Book Value Equity per Share) Cash From Operations 4,006 4,346 4,716 5,117 5,552 6,023 6,535 7,091 7,694 8,348 9,057 Cash Investments -1,800 -2,028 -2,245 -2,486 -2,752 -3,047 -3,373 -3,734 -4,134 -4,577 -5066.97 Book value of Debt and Preferred Stock 17,296 Annual Free Cash Flows 2,206 2,318 2,471 2,631 2,800 2,976 3,162 3,357 3,560 3,771 3,900 PV Factor 0.907 0.823 0.746 0.677 0.614 0.557 0.505 0.458 0.416 0.377

PV of Annual Residual Income 2,000.91

1,907.03

1,843.75

1,781.00

1,719.04

1,657.38

1,597.08

1,537.83

1,479.24

1,421.33

Total PV of Annual Residual Income 16,945

Continuing (Terminal) Value Perpetuity 54.16% 38,049

PV of Terminal Value Perpetuity 14,340 Book Value of the Firm 31,285 45.84% Growth

Book Value of Liabilities 17,296 100.00% 0 0.03 0.05 0.07 0.09

Estimated Market Value of Equity 13,989 0.08 83.62 117.52 168.97 426.2 N/A

Number of Shares 496 0.09 78.06 97.74 127.27 215.84 N/A

Estimated Price per Share (end of January) 63.07 WACC 0.1025 67.86 80.74 97.49 134.86 291.83

Estimated price per share(end of November 1) 67.86 0.1125 61.39 70.87 82.25 104.33 165.68

Observed Share Price 31.54 0.1325 51.49 56.98 62.87 72.52 91.24

Initial WACC 0.1025 Perpetuity Growth Rate (g) 0 over valued undervalued

116

Residual Income Model

Residual Income WACC(BT) 0.1025 Kd 0.0622 Ke 0.1472 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 0 1 2 3 4 5 6 7 8 9 10 Total net Income 1117 1236 1369 1515 1678 1857 2056 2276 2520 2790 Dividends 282 291 299 308 318 327 337 347 358 368 BPS (Book Value Equity per Share) 12,254 13,089 14034 15104 16311 17671 19201 20920 22849 25011 27433 Total Net Income 1117 1236 1369 1515 1678 1857 2056 2276 2520 2790 "Normal" (Benchmark) Earnings 1803.79 1926.70 2065.80 2223.31 2400.98 2601.17 2826.39 3079.42 3363.37 3681.62 Residual Income (Annual) -686.79 -690.70 -696.80 -708.31 -722.98 -744.17 -770.39 -803.42 -843.37 -891.62 PV Factor 0.8717 0.7598 0.6623 0.5774 0.5033 0.4387 0.3824 0.3333 0.2906 0.2533 PV of Annual Residual Income -598.67 -524.82 -461.52 -408.95 -363.86 -326.47 -294.60 -267.81 -245.06 -225.83 -371.76 change in Residual income -3.91 -6.10 -11.50 -14.67 -21.19 -26.22 -33.04 -39.95 -48.25 ROE 0.09 0.09 0.09 0.09 0.09 0.10 0.10 0.10 0.10 0.10 0.09 Growth 3.2% 2.9% 2.5% 2.2% 1.8% 1.6% 1.4% 1.1% 0.9% Total PV of Annual Residual Income -3717.58 Continuing (Terminal) Value Perpetuity -2525.5 PV of Terminal Value Perpetuity -639.68 Initial Book Value of Equity (per Share) 12,254 GR 2.0% Book Value of Liabilities 7,896.74 Growth 0 -0.1 -0.2 -0.3 -0.4

Estimated Share Price (February 1 2007) $15.92 0.0522 55.77 45.18 42.99 42.05 41.52

Implied Share Price (November 1 2007) $17.65 0.1156 23.28 23.65 23.78 23.85 23.9

Observed Share Price 31.54 Ke 0.1472 17.65 18.23 18.47 18.61 18.69

Initial Cost of Equity (You Derive) 0.1472 0.1988 12.12 12.53 12.74 12.86 12.94

Perpetuity Growth Rate (g) 0 0.2033 11.77 12.16 12.36 12.48 12.56

over valued under valued

117

Long-Run ROE Model

Book Value of Equity 12,254 Long Run Return on Equity 0.09 Growth Long Run Growth Rate in Equity 0.02 0.02 0.04 0.06 0.08 0.1

Cost of Equity 0.1472 0.0972 24.02 23.15 21.36 15.4 94.59

Number of Shares 496 0.1372 16.25 14 10.57 4.76 N/A

Estimated Price per Share (February 1) 13.60 Ke 0.1472 15.07 12.77 9.42 4.08 N/A

Implied share price ( November 1) $15.07 0.1772 12.43 10.18 7.15 2.87 N/A

observed share price 31.54 0.1972 11.17 8.99 6.18 2.41 N/A Growth 0.02 0.04 0.06 0.08 0.1 0.05 6.46 2.55 N/A N/A N/A ke 0.07 10.76 7.66 3.14 N/A N/A 0.0973 0.1372 0.1472 0.1772 0.1972 ROE 0.09 15.07 12.77 9.42 4.08 N/A 0.05 10.28 6.96 6.46 5.33 4.76 0.113 20.02 18.65 16.65 13.45 7.54 0.07 17.13 11.61 10.76 8.88 7.98 0.151 28.2 28.36 28.58 28.93 29.59 ROE 0.09 23.99 16.25 15.07 12.43 11.17 0.113 31.87 21.59 20.02 16.52 14.84 overvalued 0.151 44.89 30.41 28.2 23.27 20.9 undervalued within 5% fairly valued

118

Abnormal Earnings Growth Model AEG Valuation WACC 0.1025 Kd 0.0622 Ke 0.1472 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 0 1 2 3 4 5 6 7 8 9 10 Total Net Income 1117 1236 1369 1515 1678 1857 2056 2276 2520 2790 Dividends 282 291 299 308 318 327 337 347 358 368 BPS Book Value Equity 12,254 Net Income 1117 1236 1369 1515 1678 1857 2056 2276 2520 2790 Drip Income 41.51 42.84 44.01 45.34 46.81 48.13 49.61 51.08 52.70 Cumulative Dividend Income 1277.51 1411.84 1559.01 1723.34 1903.81 2104.13 2325.61 2571.08 2842.70 "Normal" Annual Income (Benchmark) 1281.4 1417.9 1570.5 1738.0 1925.0 2130.4 2358.6 2611.0 2890.9 Annual AEG -3.91 -6.10 -11.50 -14.67 -21.19 -26.22 -33.04 -39.95 -48.25 -22.76 PV Factor 0.872 0.760 0.662 0.577 0.503 0.439 0.382 0.333 0.291 PV AEG (Annual) -3.41 -4.64 -7.62 -8.47 -10.67 -11.50 -12.63 -13.32 -14.02 Total PV of AEG -86.27 Core Perpetuity Earnings -144.78 PV of terminal value -42.07 Total PV of AEG -128.34 Growth Total Average Eps perp (t+1) 988.66 -0.01 -0.05 -0.09 -0.1 -0.11 intrinsic value of per share (February 1) 13.54 0.1972 11.69 11.75 11.79 11.8 11.81 # of shares outstanding 496.00 0.1672 13.45 13.54 13.61 13.62 13.63 time consistent implied price (november 1) 15.01 Ke 0.1472 15.01 15.14 15.23 15.24 15.26 Observed Share Price 31.54 0.1272 17.04 17.23 17.34 17.04 17.39 Perpetuity Growth Rate (g) -0.01 0.1072 19.78 20.07 20.24 20.28 20.31 Initial cost of equity 0.1472 over valued under valued Change in Residual Income -3.91 -6.10 -11.50 -14.67 -21.19 -26.22 -33.04 -39.95 -48.25 Annual AEG -3.91 -6.10 -11.50 -14.67 -21.19 -26.22 -33.04 -39.95 -48.25

119

References www.macys.com

Financial reports (10k)

www.saks.com

Financial reports (10k)

www.dillards.com

Financial reports (10k)

www.nordstrom.com

Financial reports (10k)

Business analysis & valuation using financial statements

www.finance.yahoo.com

www.Onecle.com

www.investopedia.com

http://moneycentral.msn.com

Street Authority website

www.wikipedia.com

Yong Keun Yoo