Macy's: The Ultimate Show Me Story

Summary

• Macy's reported a better-than-expected 4Q2017, reporting positive owned store comps for the first time since 4Q2014.
• Asset sales and reduced SG&A allowed management to reduce leverage.
• FY2018 guidance provided support to shares, but relatively tougher 2H2018 comps require the company to execute flawlessly during the 1H.
• Upside limited until management can prove 4Q2017 was not an anomaly - next catalyst 1Q2018 earnings report.

Given the secular headwinds facing mall-based retailers, expectations for Macy's (NYSE:M) over the past few years have continued to erode. In response to the secular decline in mall traffic, M's management has pursued a multi-faceted turnaround strategy which it has dubbed its "North Star Strategy". While there has been a lot of doubt in the market related to the ability of management to execute against the challenging secular backdrop, the company seems to be signaling it believes this most recent quarter was the inflection point.

"In 2017, we tested and iterated a number of merchandising and strategic initiatives as part of our North Star Strategy. These initiatives contributed to our fourth quarter performance, and in 2018 we are ready to scale as well as test additional revenue-driving initiatives. We are also encouraged by customer response to our new Star Rewards loyalty program," (Source)

In addition to understanding the fundamental performance of M and what drove the earnings beat, I find understanding sell-side analysts' reactions and, in turn, the recommendations they are passing along to their clients, as important in determining whether the stock will continue running or if the majority of upside has been captured by others.

Source: Huffington Post

Earnings Review

For the 4Q2017, the company reported same-store comps (owned stores) of +1.3% vs. consensus of 0.4%, which was the first positive owned store comp since 2014. In addition to reporting better-than-expected comps, the company also posted better-than-expected gross margins of 38.2% (vs. 37.9% consensus), SG&A of 26.2% (vs. 27.4% from a year ago), and operating margins of 16.1% (vs. 15.6%). In addition, the company reported inventories of $5.18B, down 4.1% YoY, in an environment which it also saw sales grow 1.8%, indicating an improvement in its merchandising strategy.

Following the report, the stock has traded up ~10.5%, despite the broader "risk-off" sentiment that took hold last week.

Source: stockcharts.com

What Stood Out?

• Comps Improvement - Overall, the analyst community was impressed with the degree to which management was able to deliver a strong improvement in comps. However, there was some discussion around the temporary tailwinds that may have benefitted M in the quarter. For example, analysts cited the improved macro environment, potential rebound following hurricane season, favorable weather, and the potential impact on consumer spending from impending tax cuts.
• Inventories - One of the brightest spots of the report was M's inventory numbers, which provided support to the bulls who believe the company's improving results are rooted in strategic decisions, not just temporary tailwinds.
• SG&A and Leverage Reduction - Analysts welcomed the company's reduction in SG&A, as well as asset sales, both of which allowed the company to reduce leverage.
• Guidance - While the company clearly outperformed expectations during 4Q2017, it was M's guidance that I believe truly moved the stock. The company guided to FY18 EPS of $3.55-3.75 vs. consensus $3.05 and announced it expects to sell another $300M of assets in order to reduce leverage further. To my surprise, and the surprise of analysts, management guided that it expects FY18 comps at/above 1%, driven primarily by an expected acceleration in the second half of the year.

What Were Analyst Reactions?

Following the announcement, virtually, all analysts had positive reactions to the company's performance in the 4Q2017. Additionally, there was some anxiety related to management's ability to deliver FY18 guidance given the secular headwinds facing the industry.

• Deutsche Bank - Analysts at DB increased their price target to $29/share, implying ~1% downside in the shares.
• Gordon Haskett - Analysts at BMO upgraded M to Buy and increased their price target to $36, implying ~23% upside.
• Telsey Advisory - Analysts at Telsey rate M as Market Perform with a price target of $31/share, implying ~5% upside.
• RBC - Analysts at RBC increased price target to $31 as well
• Guggenheim - Analysts at Guggenheim increased price target to $32, implying ~10% upside from current levels.

What Lies Ahead?

While I was impressed the quarter delivered by M and believe the focus management has put on reducing leverage improves the likelihood of success, I remain on the sidelines until the company proves that the outperformance in 4Q2017 was not a one-time event. Given management's guidance for flat/slightly down comps in 1H2018, followed by an acceleration in 2H18 (leading to +1% comps for FY18), I will be watching the 1H18 comps closely. The importance of the 1H2018 reports I believe will result in the stock remaining rangebound/trading slightly down over the next few months. If the company is unable to deliver flat/slightly down 1H18 comps, it will call into question its ability to deliver the promised level of FY EPS and result in a violent selloff. Given the headwinds facing retail (XRT) and, specifically, mall retailers, the relatively tougher comps M will face in the 2H2018 and the downside risk associated with disappointing 1H results, I expect investors to remain on the sideline until management can prove its strategy is sustainable.

Conclusion

While M certainly surprised me and the street with its 4Q2017 performance, it appears that the market response over the last week (+10.5%) has limited the amount of upside in the stock until management reports 1Q and 2Q 2018 results later this year. There are simply still too many questions about M's ability to thrive in the face of secular trends for me to get involved until management "shows me" its strategy is sustainable. The shares, which are now trading at 8.5x consensus NTM EPS vs. the 3-year average of ~10x (CapitalIQ), certainly have upside should its strategy prove successful, but I will be waiting to hear more from management before believing the turnaround is real.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.