M - Macy's: Fighting To Survive But Long-Term Turnaround Seems Unlikely

2023-05-17 22:31:18 ET

Summary

• US real retail sales are falling at an accelerating pace and could decline much faster should a recession occur or import prices rise more quickly.
• Aside from e-commerce competition, department stores struggle with rising labor costs, theft rates, and weak customer satisfaction.
• Macy's is fighting to survive against the negative trends, investing in its new boutique-style store brand.
• The recent declines in Macy's profit margins signal another wave lower in earnings through 2023-2024, mainly if a recession occurs.
• While Macy's may be in long-term decline, its valuation is very low at a 4X "P/E," and it could benefit indirectly from a more immediate potential bankruptcy of Kohl's.

The American department store retail industry has been in slow decline over the past two decades due to the rise of e-commerce shopping. Many surviving companies, such as Macy's ( M ), have expanded their online footprints and consolidated stores to retain profitability. That said, few department stores have entirely stopped their declines, particularly considering they've benefited from the closure of competitors. In other words, if it were not for the bankruptcy of many of Macy's customers, the company's sales would likely be much lower today. Now that the firm has fewer weaker competitors left, the company can no longer rely on absorbing sales from closed competitor stores. Given this, I believe the company must secure a turnaround plan soon or risk bankruptcy over the coming years.

There are certain potential attractive qualities to Macy's stock. It trades at a very low forward "P/E" of 4X and a 4.3% dividend yield, which is not exceptionally high compared to its ~25% earnings yield. The stock has lost around a third of its value since its February high and is near its 52-week low today, although it remains around 2.5X above its pandemic-low price. Short interest on the stock is slightly elevated at 8%, indicating many are betting against it, but not enough to give it strong short-squeeze potential. Accordingly, if the company shows strong turnaround signs, it could be a strong "value" opportunity today.

Of course, Macy's faces multiple headwinds extending beyond its prolonged competition with E-commerce. For one, slowing US economic growth has dampened retail spending growth, potentially pushing its sales and gross margins lower and creating challenges for launching new business ventures. Secondly, prolonged supply-side inflation increases the company's overhead costs (labor, power, rent, etc.); should the US dollar decline in value and import costs rise, it could also face challenges as product costs grow disproportionately. Increased debt costs could hamper its profitability through higher interest expenses; however, this risk is partially mitigated by the long maturities of its existing debt. That said, from a longer-term perspective, I believe investors should not underestimate Macy's bankruptcy risk.

Macy's is Fighting, But Greater Change Needed

From a top-level view, Macy's has significant competitive gaps compared to Amazon ( AMZN ). Consumer prices are generally lower at Amazon than at Macy's. As consumer prices increase, more people may shift their shopping habits toward Amazon, as we've seen since 2020. Second, Amazon's product offering is much larger, both online and offline, with Macy's offering fewer "niche" products. Thirdly, Macy's business structure is less resilient to supply-side inflation due to its dependence on a more significant labor force and store overhead. Like virtually all "big box" retailers, Macy's is also struggling with a rampant increase in theft. It is racing to close stores in high-crime areas and increase theft prevention measures in its stores (further raising costs).

Historically, department stores had the benefit of allowing customers to experience items before purchasing. However, the increase in Amazon reviews and Amazon's higher customer service satisfaction and product quality ratings imply this is no longer a "positive point" for Macy's. Many people still enjoy shopping in-store more than shopping online, but I believe that benefits smaller niche and boutique stores much more. In response, Macy's is driving expansion into its "Bloomie's" brand, stores around one-fifth the size of the typical Macy's and Bloomingdale store. While this new effort could prove successful, albeit at a significant investment, it would cause internal competition as Bloomie's may steal customers from Macy's big box stores. Overall, I believe Macy's is trying to slow its decline, but not enough to end it altogether. Macy's "turnaround" CEO, Jeff Gennette, will be stepping down at the end of the year , potentially upsetting turnaround efforts at a crucial time.

Moving to the "hard data," we can see that Macy's sales have rebounded from the 2020 lockdown-induced crash; however, its sales remain on a solid trend lower after accounting for inflation. See below:

From this view, Macy's real sales per share peaked around 2017 and have fallen at ~2-4% yearly. That corresponds to the speed of decline in its overall same-store sales, indicating the slight rise in its non-inflation-adjusted sales is primarily due to capital investment efforts and its e-commerce business (~1/3rd of its current sales). More recently, the company has seen another negative shift in its gross profit margins and a slight increase in its operating overhead costs compared to sales. While the magnitude of that change is small, the fact that gross margins slipped in a relatively strong economic period (last year) is notable since a much more significant decline could occur with a recession. See below:

Of course, the company had a considerable decline in gross margins in 2020 as in-store shopping activity plummeted. 2022 saw a massive rebound in in-store shopping activity, also increasing competition among department store retailers, pushing gross margins lower. Clothing import prices rose considerably last year, causing most retailers to fail to increase consumer prices at the same pace as goods costs. The US dollar was also solid last year, reaching its record value compared to most currencies, creating negative pressure on import costs. Accordingly, should the US dollar index continue to reverse, Macy's may struggle with a more significant increase in product prices.

From a macroeconomic perspective, abysmal consumer confidence and falling real retail sales will likely exacerbate pressure on Macy's. Real retail sales are currently falling at a swift pace, with consumer sentiment still trending lower. See below:

These trends are occurring without a recession during a very strong period for the US dollar (driving import power). Accordingly, should a recession occur, and US import prices rise (due to currency weakening), the macroeconomic situation facing retailers will become far more significant. Historically, recessions are periods wherein weak businesses in unprofitable industries are phased out of the economy. While there was a recession in 2020, it was primarily driven by artificial catalysts and was backed by substantial stimulus efforts that cannot be repeated without creating a more significant inflationary crisis. As such, the US has avoided an organic recession since 2008, far longer than is typical. Thus, many "zombie firms," potentially including Macy's, could be on the chopping block should one occur.

What is Macy's Worth Today?

In my view, there is a very low probability that Macy's can turn its business around entirely. Large department stores remain more popular for older Americans than younger generations, who prefer online shopping. Over time, I believe the trend will inevitably shift toward online-only, with smaller boutique stores remaining popular for "experiential shopping." Macy's understands this bifurcation and is expanding accordingly; however, it is essentially starting from scratch with "Bloomie's," meaning its profitability remains untested, and substantial capital investments will be needed to expand this new concept.

The company has not needed external financing for its growth strategy thus far, but its working capital has generally declined, at its CapEx level has increased. See below:

In the current expensive financing market, it is wise that Macy's is not using debt financing to grow its new business venture. However, given the questionable payoff it will find in this venture, it could be best for shareholders to simply payout income as dividends and close its less profitable stores. It makes sense that the company is pursuing this strategy, which could be the key to its long-term survival. Still, it is expanding into a competitive market at a time with significant macroeconomic headwinds. Thus, I doubt it is the best strategy from a shareholder value perspective.

The one significant benefit Macy's has today is that its greatest competitor, Kohl's ( KSS ), is in a significantly worse position today. So many department store companies have gone bankrupt over the past two decades, benefiting Macy's by offering discounted acquisitions and eroding its competition. Personally, for many reasons, I doubt Kohl's will survive through 2025 should a recession occur. Macy's financial and operating position is also deteriorating, but should Kohl's fail first, Macy's life could be prolonged. See how they compare below:

Macy's sales are not slowing as quickly, its operating margins are not falling as fast, and its liquidity is more stable. Unlike Kohl's, Macy's has no significant debt maturities until 2027, with its greatest being in the 2029-2034 horizon. Considering financing costs are likely 2X+ greater today (due to increased rates and credit speeds), this factor dramatically reduces Macy's immediate solvency and liquidity risk. However, Macy's cash position is not extraordinary, and it is making significant investments today, so trouble may arise if it fails to maintain profitability over the coming year or two, likely causing it to need expensive external financing.

Overall, I believe Macy's is nearly fairly valued, given its financial and operating position today. Its forward "P/E" ratio is around 4X. While its real revenue and operating margins are falling, implying a potentially sizeable negative trend in EPS, it is significantly discounted according to that risk. Further, while I believe Macy's is a "going concern," it can likely outlast some of its department store competitors. In my view, growing recession risks and the significant slide in US real retail sales may accelerate Macy's decline over the coming year, so I am slightly bearish on the stock today. That said, at its current valuation and its 52-week low price, I do not believe it is a short opportunity today. Should Macy's specific situation or the broader macroeconomic environment deteriorate more rapidly, I would likely be more bearish on the stock.

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