Patching Up Margins with Real Estate

Graphic Designed by: Aaron Chow

BRB Bottomline: Operating margins tell an investor a lot of about the underlying economics of a business, and managers of public companies know that. In an investment landscape where big data analytics dominate the screening process by streamlining investment allocation into companies with certain fundamental characteristics, the minutia of how those metrics are calculated have fallen to the wayside. This leaves a gap for financial statement investigators and arbitrageurs to produce interesting insights into how companies manipulate and manufacture margins to tell management’s story.

Macy’s (NYSE: M) filed its quarterly report for the three-months-ended June 30th, 2018 last Friday and included Gains from Sale of Real Estate as part of Operating Profit—instead of Other Income—which both inflates Operating Margins and represented one-quarter and one-third of second quarter 2018 and full-year 2017 Net Profit, respectively. 

The operating profit (loss) section of the income statement is reserved for profits and losses that regularly occur as a normal part of operating the business. Looking at where Macy’s places Gains from Sale of Real Estate, we must assume that management considers selling real estate as “normal” as other operating income/expenses.

In an era of big data analytics, especially when large institutional investors screen for investments and rebalance their portfolios based on big quantitative passes, investors often lose sight of how margins and growth rates can be manipulated. Insights like these are testaments to the importance of standardizing financial information before using it to make investment decisions. These technicalities also shine a light on the nuances of specific company financial statements and how easily managements are able to manufacture numbers.

Wall Street’s Suggestions for Macy’s

At the end of 2016, Starboard Value, an activist hedge fund, published a report calling on Macy’s to spin-off its real estate portfolio into a separate REIT so that investors can realize the value of those owned buildings. The REIT spinoff and structure would be doubly tax-efficient because not only are spin-offs are tax-free but also REITs don’t pay corporate taxes; moreover, the separated structure increases visibility on the rent that Macy’s real estate portfolio commands, which, in the current combined structure, is unreported.

Macy’s declined to follow Starboard Value’s urgings, despite the hedge fund’s successful real estate spinoff, Four Corners Property Trust (NYSE: FCPT), which holds the real estate portfolio previously owned by Darden Corp. (NYSE: DRI), the owner of Olive Garden and Red Lobster.

Reasons Why Macy’s Demurred

Instead, it has been surreptitiously selling off real estate, which isn’t tax-efficient, to pad operating profits in a period where full-line department store traffic is waning. For example, Signet Jewelers (NYSE: SIG), the owner of Kay’s, Zales, and Jared’s, has been cutting mall-based jewelry stores by the hundreds and opting for neighborhood strip malls. The reasons for keeping Macy’s real estate portfolio on its own books as opposed to in a different entity is several-fold, which I’ll go through in cursory detail: 1) management is operating the business as an empire and prefers to keep as many assets as possible under its purview, 2) the added boost in profits from real estate sales pads profits even whilst being tax-inefficient, 3) any spinoff might exacerbate reported negative trends in sales and margins, more so than management would like to admit, and 4) management is complacent and lazy.

Instead of showing Gains from Sale of Real Estate in the Operating Income section of the income statement, Macy’s should be reporting those gains in Other Income because, while those sales generate accounting profits due to the historical cost principle, they aren’t core to the business’ continuing operations.

Margins Tell a Story

This write-up isn’t to say you should short Macy’s stock because management is disingenuous. Rather, I’d like it speaks to a broader message of financial information due diligence.

For example, Tesla is the only automaker to report R&D separately from Cost of Goods Sold (“COGS”) because it wants to impress upon investors that it has higher gross margins than its competitors, which proves that it is a tech company deserving of a tech company valuation; tech companies are priced on a multiple of Net Sales, whereas automakers are priced on a multiple of Net Profits, which Tesla doesn’t have.

Take Home Points

Margins can tell a story about a company. Therefore, management shifts sales, in the case of Macy’s, and expenses, in the case of Tesla, to different parts of the income statement to corroborate the story that it wants to tell. As a prudent investor, you must be cognizant of the ways accountants manipulate financial information so that they don’t dupe you into buying something that is really something else.


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