Macy’s Stock: Q4 Results Are A Cause For Optimism (NYSE:M)

Macy’s (NYSE:M) shares have been a material underperformer over the past year, losing about 9% of their value. Retailers were overly optimistic about consumer spending in H2 2022, leading to excess inventory and significant margin compression. However, many of these pressures have faded, and since recommending shares as a buy in November, Macy’s has returned about 40% for investors, moving past my $17 price target. Macy’s shares have been volatile since reporting earnings, and after initially spiking, they are now below pre-earnings levels. While its turnaround plan will take time to realize, I would continue to stay long Macy’s stock, even after its large run.

In the company’s fourth quarter, Macy’s earned $2.45, beating expectations by $0.46, even as revenue fell by 2% to $8.4 billion. Gross margins came in particularly strong at 37.5%, up by 340bp, as much leaner inventories have allowed the company to be significantly less promotional. For the full year, adjusted earnings were $3.50 as sales fell by 5.5% to $23.1 billion. Same store sales were down by 4.2% in Q4, while credit card revenue fell by 26% to $195 million, due to normalizing credit losses after extremely low levels last year. The Macy’s brand’s same store sales were down 4.7% with Bloomingdales down 1.6% and BlueMercury up 2.3%.

Given this relative performance, the company announced that it will be closing 150 of its 500 Macy’s locations. Even as that represents 30% of its store count, these stores contribute just 10% of sales, which speaks to how low their productivity is. Offsetting this, the company plans to open additional “small Macy’s” at open-air malls, Bloomingdale’s, and BlueMercury locations. This shift away from poor-performing mall-anchored Macy’s locations to better-performing locations and brands should help the company sustain the margin improvement we have seen this year. This is a transformation likely to take 2-3 years, given the time required to exit leases and open new stores. Macy’s will exit it a leaner, more productive company, which should benefit shareholders.

These store closures should generate $600-$750 million in proceeds, which can be used to finance new locations and support shareholder returns. As a result of this transformation, over 2024-2026, Macy’s aims to return to sales growth and return to pre-COVID free cash flow levels. While this goal is ambitious, full-year 2023 results leave me optimistic that it is attainable.

In Q4, even as revenue fell by 2%, gross profit increased by 8% to $3 billion, which speaks to the power of the margin expansion we are seeing. Adjusted EBITDA increased by 28% to $1.17 billion, with margins up 330bp to 13.9%. In addition to less markdown activity, delivery costs improved by 80bp from last year as supply chain cost pressures have normalized. Macy’s also reduced SG&A spending by 2%, exhibiting strong cost discipline in a difficult top-line environment.

Significant improvement in how Macy’s is managing its merchandise is the critical driver in its margin expansion story. Inventory finished Q4 at $4.36 billion, up 2% from last year, partly due to the new offerings of Nike (NKE) and Under Armour (UA) products. Taking a step back, inventory is now 16% below 2019 levels, with inventory turnover up 12% over the past four years. With this lower level of inventory, M is moving products more quickly, leaving it with less product at the end of a season that it needs to sell at a significant discount in order to free up shelf space for new products.

Importantly, management does not expect this margin improvement/inventory rationalization momentum to end. In 2024, Macy’s is guiding to an additional 40-70bp of margin expansion vs. 2023’s 38.8%. It expects to end Q1 with inventories flat to last year’s levels. This margin expansion will continue even with same-store sales that are essentially flat from last year.

I believe the macro environment is likely to be supportive of this outlook, while even creating the potential for a modest upside surprise. As you can see below, when COVID-19 happened, sales of apparel plunged well below the prevailing trend level. It then soared in 2021 as the economy reopened, and consumers spent their stimulus checks. Retailers positioned inventories for ongoing sales growth in 2022, but with spending so far above trend and inflation picking up, spending on apparel stalled out. As a result, apparel spending has basically been flat for two years, forcing a wave of markdowns in 2022 that hit margins.

After two years of no growth, apparel spending has converged back down towards its prevailing trend. In other words, while in 2021, consumers were spending a disproportionate share on clothing, they now are essentially spending what we would expect them to, given prevailing long-term trends. Without excess demand, we are positioned for modest sales growth in 2024, though of course not every retailer will benefit equally.

I would also caution that if we see a recession, spending on discretionary items like clothing would likely fall. However, in my view a recession is unlikely, and the labor market remains strong. This sets up the industry for modest (0-3%) sales growth, which combined with Macy’s better inventory position should support margin expansion. Essentially, 2021 saw retailers enjoy outsized gains, which they gave back in 2022, and 2023 was about “returning to a normal run rate.” Macy’s exits this period with a strong inventory position and greatly improved margins.

In the meantime, its business continues to be solidly cash generative. In 2023, Macy’s generated $398 million of free cash flow, with which it paid $181 million in dividends and $25 million in repurchases. As a result, Macy’s is carrying $1 billion in cash, up by about $170 million from last year. I would also note that working capital was a $600 million headwind, primarily due to a $347 million decrease in accounts payable (about 13%). Macy’s goal for 2024-2026 is to return to its pre-COVID level of free cash flow. In 2019, Macy’s generated $812 million in free cash flow, and in 2018, it was $983 million. That is a credible target just by expanding margins and holding working capital relatively flat.

The retail industry is obviously undergoing major secular changes. Macy’s large cash position and positive free cash flow is a reason I view it favorably as an entity likely to make it through this period of change. Additionally, it has a strongly positioned balance sheet with a well-laddered debt maturity profile. Macy’s does not have a material debt maturity until 2028. With proceeds from store and distribution center closures, it can address these maturities and further push out debt maturities while also paying its dividend and modestly repurchasing shares.

Given how far Macy’s has run, it is perhaps not that surprising to see some profit-taking after earnings. However, I view these results favorably with solid cash generation and continued margin and inventory progress. Moreover, its efforts to shift towards more luxury consumers with Bloomingdale’s and a move away from big-box mall locations to smaller open-air locations are consistent with where consumers are shopping.

This is a transformation that will take time, but given the fact consumers are now not overspending on apparel, sales growth should be easier to come by, increasing the likelihood of success. Shares are below 8x 2024 earnings, and with free cash flow likely to be at least $500 million, given lower cap-ex and more favorable working capital dynamics, I believe investors are being paid to wait for the transformation to occur. If we do see comparable store growth turn positive as I expect in 2024, given the more favorable macro environment, I believe shares could push towards 10x earnings, or into the $22-24 area, creating sufficient upside to stay long and use weakness to add to positions.