Macy's: Still No Reasons For Optimism

Investment thesis

On February 10, I wrote my first article about Macy's (NYSE:M), which I called "Neither Value Nor Growth" with a Strong Sell rating. I faced a lot of disagreement in comments, but the stock has declined more than 20% from that date, despite during the last earnings announcement, M delivered a confident beat in terms of EPS. So, I would like to update this article's financial analysis and valuation.

Financials still look weak

On March 2, Macy's announced 4Q2022 financials delivering higher than consensus EPS and lower than consensus revenue.

From a top line perspective, the company demonstrated a decline across almost all revenue metrics. Net sales were $8.3 billion, down 4.6% compared to the fourth quarter of 2021, and digital sales decreased by 9% versus the same period. In addition, brick-and-mortar sales decreased by 2%, and comparable sales were down 3.3% on an owned basis and 2.7% on an owned-plus-licensed basis versus the fourth quarter of 2021.

From a profitability perspective, the dynamic was decelerating as well. The gross margin for the quarter was 34.1%, down from 36.5% in the fourth quarter of 2021 due to higher markdowns and promotions.

The company attributed its performance YoY primarily to macroeconomic pressures on the consumer, a lack of government stimulus benefits, and a heightened competitive retail environment driven by industry-wide inventory surpluses. While the company experienced sales strength in gifting and occasion-based categories, sales in active, casual, and soft home declined versus the prior year.

On a full-year basis, the company also demonstrated lackluster financial performance with several negative trends across key metrics, mainly due to the challenging retail environment. As a result, trends are negative across several critical metrics.

Net sales remained relatively flat at $24.4 billion, a 0.1% decrease compared to the previous year, and digital sales decreased by 6%, which is concerning given the ongoing shift towards e-commerce. Brick-and-mortar sales increased slightly by 3%, but this was not enough to offset the decline in digital sales.

The company's comparable sales increased by 0.3% on an owned basis and 0.6% on an owned-plus-licensed basis compared to the previous year. This is a significant decrease from the growth seen in 2019, with comparable sales up 3.5% and 3.7%, respectively. The company's active customer base also decreased by 4% for the Macy's brand, and while Bloomingdale's saw a 5% increase, more was needed to offset the decline in the more prominent Macy's brand.

Gross margin for the year was down to 37.4%, primarily due to planned markdowns and promotions, as well as a shift in consumer demand away from pandemic-related categories towards occasion-based categories. The company's SG&A expenses also increased by $270 million, and SG&A expense as a percent of sales was 34.0%, 110 basis points higher than the previous year. While the company invested in talent and adjusted colleague compensation to remain competitive, this expense increase likely contributed to the overall decline in financial performance.

For FY2023, management expects that macroeconomic uncertainty will persist throughout the year. As a result, there is no good news about management's outlook, in my opinion. You can find the complete fiscal year 2023 outlook on the company's investor website but don't expect good news. For example, Macy's predicts that net sales will drop between 3% and 1% compared to 2022, with a comparable owned plus licensed sales change expected to decrease between 4% and 2% versus 2022. EPS is also expected to decline, so overall, the outlook is negative.

Valuation update

As I did during my last analysis, I use the dividend discount model [DDM] to value Macy's stock fair price. WACC has softened, according to Gurufocus, closer to 8%. But so did the dividend growth rate, according to Seeking Alpha Quant rates. Last time it was 4.57%, but now I use 3.96%. It is fair, given declining financial metrics together with a negative outlook.

Incorporating all the updated assumptions gives me a fair value of 16.34%, indicating a slight overvaluation of 4%.

Here I would like to simulate a higher WACC because I only partially agree with Gurufocus' decreasing estimate of the company's WACC, given increasing FED rates and uncertainty regarding further hikes. Thus, I would like to implement a WACC of 8.94%, which I used in February. In this case, DDM indicates 22% overvaluation.

Overall, DDM suggests the stock is overvalued, and the company's earnings estimates for upcoming years need evidence that there are reasons for optimism, with EPS expected to stagnate over the next decade.

Recession risk grows

All risks described in my previous article about Macy's are still in place, but I would like to emphasize that recession risks have increased over recent weeks.

Nobel Prize-winning economist Paul Krugman wrote in his New York Times column that the recent collapse of Silicon Valley Bank, Signature Bank, and the government-backed takeover of Credit Suisse (CS) by UBS (UBS), as well as mounting pressures on First Republic Bank (FRC), have increased the chances of a recession in the US. However, Krugman dismissed "apocalyptic warnings about hyperinflation and the dollar's imminent collapse.

Moreover, Minneapolis Fed president Neel Kashkari also believes that recent stress in the banking sector brings the U.S. closer to recession.

Macy's is a retail department shop highly dependent on consumer spending. A recession may cause consumers to reduce their discretionary spending on non-essential items such as clothing, household goods, and accessories. During a recession, consumers may also be more inclined to shop at a discount or online retailers, which could lead to a decline in customer traffic at Macy's stores. This could result in lower sales and revenue for the company. In addition, a recession could also affect Macy's supply chain, as suppliers could have difficulty meeting demand or go out of business. This could result in shortages or delays in the delivery of products, which could further adversely affect Macy's sales and earnings.

Risks to my thesis

While my bearish thesis is working well, it has risks.

First, there is currently high uncertainty about the Fed's next steps in regards to the interest rate. If the Fed does not raise rates at the nearest meeting and a potentially dovish speech by Mr. Powell end up being a very bullish signal to the whole market, Macy's stock will not be an exemption. Moreover, a more accommodative Fed policy will mean a turnaround in consumer confidence and spending, which would benefit Macy's business.

Second, we cannot exclude the possibility that the Board of Directors might change the management. Leadership changes can significantly impact a company's operations and financials, and Macy's is no exception. If Macy's brings in a new CEO or top executives with a strong track record of turning around struggling companies or implementing successful growth strategies, this could lead to a renewed sense of confidence among investors. In addition, a new leadership team could bring fresh ideas and perspectives to the company and be better equipped to navigate the retail industry's challenges.

The third good news driver for Macy's might be its Digital initiatives. While there is significant competition in the e-commerce space, Macy's has the advantage of its large customer base and established brand recognition. Therefore, suppose it is successful in its e-commerce initiatives. In that case, it could be well-positioned to capture a larger share of the growing online retail market, which could positively impact its financials and stock price.

Bottom line

To conclude, the company's latest earnings did not add any optimism, given the declining financial performance in 4Q2022 and the full FY2022. Moreover, management's outlook for FY2023 is negative, and consensus estimates for the next decade suggest that almost no growth is expected for either the top line or EPS. As a result, I remain bearish on the stock; however, the stock price is now closer to fair value, though still overvalued.